The Biggest Losers Redux: F&F Delenda Est

There is a viral rumor that Fannie Mae (FNM) and Freddie Mac (FRE) will unilaterally reduce the principal amounts owed on underwater mortgages.

This is generating a lot of criticism, and talk of “bailout.”  Yes, there is probably a bailout element to it, and the political timing would be highly suspect.  But to the extent these mortgages are underwater, F&F are eventually going to eat losses.  Any such program, if rumor is fact, will not be entirely a bailout.  The program would be a mixture of political payoff and recognition of reality.

But even the rumor and the credence many people give it emphasizes a point I’ve tried to make repeatedly about F&F.  Namely, that those who strive mightily to absolve F&F of any responsibility for the housing boom and bust refuse to come to grips with the GSE’s massive losses.  The losses already recognized are huge.  The rumor is essentially an acknowledgement that the losses to come are, er, huger.

Those who defend F&F tiresomely point to statistics about the measured characteristics of F&F’s portfolio, e.g., the percentage of subprime and Alt-A.  They argue that F&F’s participation in such lending was small, compared to non-GSEs.

But the ultimate measure of risk and credit quality is realized performance on the portfolio.  F&F’s huge losses demonstrate that the credit quality of the portfolio was actually quite low, that the value of the portfolio was quite sensitive to housing prices and/or concentrated in overpriced regions, or both.  Most likely, both.   In other words, the huge losses say far more about the credit quality and housing price risk of the portfolio than analyses based on characteristics measured ex ante.  Especially inasmuch as there is reason to believe that F&F fudged these measurements (and isn’t fudging one of Fannie Mae’s main activities?) in order to  increase the amount of credit extended to riskier borrowers in the most bubbly and overpriced markets, while maintaining the pretense that it was continuing to maintain underwriting standards.

The proof of the pudding is in the eating.  We are now eating F&F’s losses.  They demonstrate, quite forcefully, that their brand of pudding was rotten.  Going on and on about statistics allegedly demonstrating the quality of the ingredients doesn’t mean squat if the first bite makes you puke.

The rumor relates to the consequences of past actions.  Sunk costs are sunk.  What is a mistake is to ignore the causes of these past actions, and to repeat the mistakes going forward.  Fannie Mae, however, is falling back into bad habits:

The Washington Independent has an excellent story today about an ongoing housing programme in the US that is almost breathtaking in its stupidity.

Known as “Affordable Advantage”, it involves a kind of partnership between Fannie Mae, the government-sponsored enterprise, and the housing finance agencies of individual states. Here’s the explanation from the Washington Independent:

Before the recession hit, these housing finance agencies, known as HFAs, issued tax-free bonds and used the funds on programs to encourage developers to build in underserved areas and to support single-family mortgages. When the financial crisis hit, private companies — leery of the collapsing housing bubble and freezing mortgage market — no longer wanted to buy the HFAs’ bonds.

Then Fannie Mae entered the scene, agreeing to buy these bonds under the assumption that the homeowners had strong credit histories. In exchange, the HFAs said they would buy back loans that went delinquent.  And this is how the programme now works (also from the Washington Independent, emphasis ours):

Now, qualified homebuyers in the three states pioneering Affordable Advantage do not need to put down the 3.5 percent minimum down payment required by the Federal Housing Administration, or much of a down payment at all. They can get 100 percent financing — a loan as big as the purchase price of the house — for a 30-year, fixed-rate mortgage — a vanilla mortgage. The deal includes a program to help homebuyers if they become unemployed, lowered fees and there is no requirement that the homebuyer purchase mortgage insurance.

The only requirement is a $1,000 downpayment.  Perhaps you can already see where this is going.

Yeah, we can see where it’s going because we’ve already been there.  ”Groundhog Day” is not a business plan.

But what’s the one thing that the “financial reform bill” didn’t do?  That’s right: it didn’t do a damn thing about F&F.

So if the rumor about F&F’s treatment of existing mortgages turns out to be true, that will be less worrisome than the things that they continue to do and are likely continue to do going forward.  The only way to prevent that going forward is to put these monstrosities down, with extreme prejudice.

About Craig Pirrong 223 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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