I'm feeling mighty patriotic this morning as I watch "The Redeem Team" thrash the Chinese in B-Ball! I don't even like basketball and I'm yelling things like, "get that weak-ass sh*t out of the paint!" Speaking of weak-ass sh*t, what are we going to do with Fannie and Freddie?
I think the first thing we need to do is have a serious debate as to whether or not we want to keep subsidizing home ownership. If we don't , then it's an easy answer. "Adios amigos." Before we rush to that decision however, lets talk a bit about how a very large part of housing finance currently works.
- Wells Fargo makes $1billion 30-year 6.5% fixed rate mortgage loans that will close mid to late September. These loans conform to Fannie Mae and Freddie Mac underwriting guidelines.
- Wells Fargo sells a $1 billion of Freddie Mac mortgage backed securities (MBS) to Credit Suisse MBS dealer desk, to settle in October for a price of 100-00 (par).
- The rate on the MBS that Wells sells to Credit Suisse will be 6%. The loans that will be making up the MBS are 6.5%. What happened to that .50%?
- Freddie Mac takes .12% of the 6.5% interest payment every month. That is its premium to guarantee this mortgage backed security.
- The remaining .38% of the interest payment is kept by Wells Fargo to compensate the company for servicing (collecting principal and interest, escrowing and paying for taxes and insurance, handling delinquencies, and if necessary dealing with the default and foreclosure process) the loans.
- In October, Wells makes delivery of $1 billion Freddie Mac 6% MBS to Credit Suisse, who most probably has sold the bonds to an end investor.
- Rinse, lather and repeat thousands and thousands of times.
You see that in step 4, Freddie (could be Fannie as well) provides the credit insurance which allows the eventual Freddie Mac MBS to trade credit risk free. Currently, the amount of Freddie Mac and Fannie Mae 30-year Fixed Rate MBS outstanding is about $2.7 trillion. This is the most liquid fixed income market in the world of finance. It is heavily utilized by what we call "real money" like pension funds, money managers, banks, insurance companies, foreign governments, etc. It is also heavily utilized by the very large hedge fund community. This harmonious (keeping in spirit of the Olympic Games) relationship between dealers, real money and speculative money makes this market for Freddie Mac and Fannie Mae MBS extremely liquid.
Now, you may be saying to yourself, "Who cares?" Well, everyone should care because when Wells Fargo sets its rate for your mortgage loan, it is zeroed in on the execution it gets when it sells your loan into what we call, the "secondary market". If that secondary market breaks down, the whole machine breaks down and suddenly your 6.5% loan is a 8% loan. How do you think that will effect the economy? This is how we have been subsidizing homeownership for at least twenty five years. And up until recently, before everyone lost their minds, it worked pretty damn well. The subsidy is Freddie and Fannie underwriting the credit insurance while being implicitly (now effectively explicitly) backed by the U.S. Government.
Taking this method of subsidizing home ownership and replacing it with ideas that sound good but won't go much past the inaugural press conference (like covered bonds), will effectively cut off relatively cheap home financing. If you think that is ok, then you can stop reading. Personally, I think it would be catastrophic, and I say that in context of the current catastrophe!
I think the correct thing to do is first call in a team of forensic accountants to classify, that according to Generally Accepted Accounting Principals, both Freddie and Fannie are insolvent. Once you go through the completely unreserved $35 billion of "Tax Deferred Assets" and the approximate $30 billion"Temporary" losses in the securities portfolios that haven't hit the income statement or equity, it's over and common and preferred stock goes to zero. We can sit and wait another few months until the arithmetic takes care of things, but it will just be a waste of time and money. I don't mean to be harsh, but this is the reality. Freddie and Fannie will now be the prized property of The U.S. Government.
Next, we merge the two companies under the name of the more liquid MBS, Fannie Mae. All Freddie Debt is converted to Fannie. Additionally, Freddie Mac MBS would be converted to Fannie MBS. There is a difference in interest rate calculation between Fannies and Freddies that will effect the conversion and have some nasty effects (or nice effects) on security holder earnings, but so be it. In the grand scheme of all that is going on, its not a big deal. Then we split the companies two main business lines into two distinct entities.
- The mortgage credit insurance (or guarantor) business.
- The Retained portfolio (the combined $1.5 trillion portfolio of mortgage investments funded with agency debt and hedged with interest rate swaps and options)
For the insurance business, we ring-fence the existing book of business. This contains the bad business that will be generating billions of losses, but it also contains good historic business as well as the very good business Freddie and Fannie have been underwriting in 2008. This will be the book that you and I own, and there will be losses. However, there's good news! Now that our "new" Fannie Mae is the only real game in town with regard to guaranteeing the credit of conventional conforming mortgages, they can charge a real nice premium for all new business done starting in 2009. And trust me, all this will mean to you and I, as mortgage borrowers, is about .125% to .25% on your note rate.
One of the big problems Freddie and Fannie caused for themselves is they got into an incredibly self-destructive price war with one another. Normally, competition is good, and it was if you were Countrywide or one of the other big originators. But that "competition" is one of the reasons Freddie and Fannie are now going toes up. If you saw some of the deals the GSEs cut with the big originators to win their business from one another you would literally fall out of your chair! Coming into this decade, the insurance business the GSEs had on their books was very strong. It took approximately twenty five performing loans to make up for the loss of one bad loan. By the time the price war ended, it took more than fifty loans to make up for one bad one! Additionally, both companies spent millions, maybe billions in advertising and marketing. Why did they do this you ask? To win business from one another of course! There's an expense you don't have to worry about anymore. We won't have to spend another dime on lobbying either. Oh, and Dan Mudd and Dick Syron can go back to what ever it was they were doing before the money fairy dropped them into their current positions.
So, once we get the pricing back in line, as Freddie and Fannie are already doing, I bet we can get a past GSE investor, Warren Buffet, to come back and participate in a joint venture. He can come up with the first $2 billion by selling his 20% stake in that pile of garbage Moody's! I can see him coming in with a good $10 billion and I bet we can get a syndicate of investors to raise some serious capital. The government will have to kick in too, but this will be a profitable venture for all involved.
Now we have to deal with the $1.5 trillion retained portfolio. Frankly, the GSEs, especially Freddie Mac, do a nice job with this part of the business. It's essentially a gigantic mortgage hedge fund. The guy who runs this at Freddie Mac may be the sharpest fixed income mind on the planet. I'm not kidding. They take the funding and the hedges and run it for us. We'll have to put a few billion of capital in but it will be worth it. With regard to funding, I like the idea Bill Ackman had. Right now if you own 5-year Fannie or Freddie debt you are getting approximately .88% over the risk free 5-year Treasury note. The main reason for that spread is potential credit risk (there's also liquidity risk but agency debt is plenty liquid). Now, with the explicit backing of Uncle Sam, there is no credit risk. To some degree, an agency debt holder is accruing the benefit now of a partial equity holder. Ackman's idea was to convert a percentage of this debt, via a swap from holder to issuer, to preferred equity. If you did it 90% debt and 10% equity, we would have all the capital we need for our mortgage hedge fund.
I think we can do this, keep the bedrock of our housing finance system in place, minimize losses and eventually create gains in the future to offset a good amount of this Fannie/Freddie debacle.