14 December 2009

Fed Moves Into Fannie Mae and Freddie Mac Role

In normal times, the Federal Reserve owns lots of federal government debt (aka Treasuries), a little bit a short term bank debt, and some miscellaneous assets. But, these are not normal times.

A year ago, the Federal Reserve was providing large volumes of short term loans to big business, a line of business called commercial paper that is usually reserved for ordinary banks, because ordinary banks had grown terrified of lending even for these very safe loans, and it was also providing immense amounts of short term lending to other banks something that is also usually provided by other banks. Together, this lending by the Fed had reached the phenomenally high level of $1.7 trillion dollars. Now, this kind of lending is down to about 10% of those levels. This is still more than normal, in an institution that usually has a little less than $1 trillion of loans, well under $100 billion of which is short term lending to banks and none of which is short term lending to businesses, in ordinary times. But, it is no longer an amount that is grossly off the charts. These short term efforts, like the Fed's short term commitment to prevent a run on the money market fund industry, have largely come and gone after a brief period of panic.

The Federal Reserve also never buys mortgage backed securities in normal times, and a year ago it didn't own any meaningful amount of them. Buying mortgage backed securities is normally mostly the job of the federally chartered, but privately owned Fannie Mae and Freddie Mac, and by Ginnie Mae, a federal government agency. Now, the Fed owns $1.06 trillion of mortgage backed securities and plans to bring its holdings to $1.25 trillion over the next three months.

When the Fed is done, it will be owed about two and a half times as much as it was before the financial crisis, about half of that in mortgage backed securities. The agency backed mortgage backed securities portfolio alone is larger than the entire Fed portfolio, pre-financial crisis, and about 10% of the size of the entire national debt. The federal budget is about $3 trillion per year.

These mortgage backed securities aren't exactly issued by fly by night operations (or even investment banks or money center banks). They are "agency backed," by entities like Fannie, Freddie and Ginnie. In all, about $5 trillion of mortgage backed securities are agency backed and another $2.5 trillion are privately securitized. The Federal Reserve is buying about a quarter of all outstanding agency backed mortgage backed securities.

In Fannie and Freddie guarantee investors in their the mortgage backed securities that they issue will not default. In theory, those promises are backed only by the assets of Fannie and Freddie respectively, although many investors think that the government will bail out this too big to fail, government affiliated institutions, rather than let them go bankrupt, if they can't meet their obligations as a result of the current wave of mortgage defaults.

Ginnie makes the same promise, but that promise is backed by the Federal government, the same way that Treasury bonds are guaranteed. These investors have a right to be bailed out that they bargained for in advance.

It isn't entirely obvious why the Fed was given the job of buying agency backed mortgage backed securities. Like many things related to the Fed, it is obscure.

This may help clear the balance sheets of the agencies to give them the capacity to make more loans, now that private mortgage backed securities markets have contracted, but that could have been done simply by increasing the lending authority of the agencies.

This may be designed to shift losses from the agencies to the Fed, but it isn't obvious why an agency loss, perhaps bailed out with a federal government program, is worse than a Fed loss. For that matter, what does happen if the Fed takes a loss on these investments? Is this a loss that the shareholders in the member banks bear, or is this a loss that taxpayers suffer? Would it matter if Fannie Mae and Freddie Mac were bailed out, but a large share of the bailout money went to the Fed rather than individual mortgage backed security investors?

Is the desire to have the Fed pick up these mortgage backed securities mostly a product of how they appear in federal government accounting reports, keeping them out of the national debt, perhaps, while Ginnie Mae debts might be reported differently?

Even if some federal government affiliated entity need to buy these securities for some reason, why should the Fed, which normally doesn't buy securities at all, let alone mortgage backed securities, be assigned this task? Fannie and Freddie have had some management problems. But, the Fed is not precisely a bastion of good management either. Recall that the Fed was the primary regulator of AIG, which was pretty much at the top of the finacial crisis pyramid. The Fed has no experience in this kind of transaction. Fannie and Freddie came out far better in the mortgage default driving financial crisis than investment banks and private mortgage investors carrying out essentially the same activity with a different pool of loans. The FDIC has far more experience handling porfolios of potentially troubled loans than the Fed does. Ginnie Mae could also be given authority to engage in this kind of transaction as a special class of its operations.

Is the theory that the job of the Fed is to make loans (which is what one is doing when one buys a mortgage backed security) that the market has irrationally failed to make until panic subsides?

I don't have the answers. If the agencies manage to keep their promises that these mortgage backed securities won't default, the public policy concerns are pretty modest. But, anytime you do something like putting real risk in an institution like the Fed that wasn't designed to make loans that carry real risk, one wonders if the job will be done right. And, this is a very, very big job, even for the Fed.


Michael Malak said...

The reason Fannie Mae and Freddie Mac were bailed out was to bail out China. If the U.S. government had not bailed out Fannie and Freddie, effectively the U.S. would be repudiating its debt to China, which theoretically could have escalated into tariffs, trade sanctions, embargoes, even blockades and war.

So a more proper headline would have been "Fed Moves Into China Role". Fannie Mae's leadership used to talk about the need to seek Asian capital to provide liquidity to the U.S. mortgage industry. Now, that job apparently falls on the Federal Reserve.

andrew said...

So far, Fannie and Freddie have been placed into conservatorship, their dividends have been slashed, and the Fed and the Treasury have essentially loaned them more money that has a reasonable probability of being repaid.

But, they have a far lower default rates in their loan portfolios than the private sector, and it isn't obvious that they have actually cost anyone who is owed money by them (even subordinated debt) a dime yet.

Will the Fed take a loss on its purchases? It might, but it isn't clear that it has yet or that it is particularly likely that it will.

The notion that China is being bailed out is ridiculous.

Michael Malak said...

I was trying to answer your question, "This may be designed to shift losses from the agencies to the Fed, but it isn't obvious why an agency loss, perhaps bailed out with a federal government program, is worse than a Fed loss."

I don't follow your logic of how you deduced, "The notion that China is being bailed out is ridiculous."