February 24, 2004

Mortgage Risk Comes Out of the Closet

Alan Greenspan is in a candid mood, which is fortunate for us. We get to see how absolutely insane the man is. His testimony before the Senate Committee on Banking, Housing, and Urban Affairs was a revelation for anyone wanting to know the nature of the systemic risk posed by the GSEs (something I covered in the Housing Report.) But while Greenspan diagnoses the risk correctly, he subscribes to the theory that disseminating credit risk throughout the world, through mortgage bonds, actually reduces rather than distributes risk. Hard to see how he reaches that conclusion when the testimony of his speech seems to counter it. Below, I offer a few choice quotes. You can find the whole thing here. Fannie (FNM) and Freddie (FRE) are down as I write this. And if Washington does get its act together to put a lid on how fast the GSEs are expanding their balance sheets--without making it seem like the Federal government is worried it's going to have make good on GSE bonds--well then, that would be bad news for Fannie and Freddie stock. "Although the risk that a home mortgage borrower may default is small for any individual mortgage, risks can be substantial for a financial institution holding a large volume of mortgages for homes concentrated in one area or a few areas of the country." Denning comment: Think J.P. Morgan. "Securitization by Fannie and Freddie allows mortgage originators to separate themselves from almost all aspects of risk associated with mortgage lending: Once the originator sells the loan into the secondary market, he or she may play no further role in the contract." Denning comment: And this is good how? Lender makes loan. GSE buys loan from lender, taking loan off lender's books and freeing lender up to make new loan. Who owns the loan (the risk.) Not the lender, but the GSE. But wait, GSE securitizes loan and sells it to....pension fund, mutual fund, hedge fund, foreign government. Who owns the loan (risk)? We all do! "...the sources of credit available to purchasers of cars and users of credit cards have expanded widely beyond local credit institutions. Unbeknownst to such borrowers, their loans may ultimately be held by a pension fund, an insurance company, a university endowment, or another investor far removed from the local area. This development has facilitated the substantial growth of non-mortgage consumer credit. Indeed, in the United States, more than $2 trillion of securitized assets currently exists with no government guarantee, either explicit or implicit." Denning translation: Millions of Americans are, to some degree, dependent on the mortgage payments of other Americans they've never met. Ironically, the GSEs have both concentrated interest rate risk and disseminated like an addictive drug to the bond market. They've concentrated it because they are the middle man. The GSEs guarantee mortgage debt and buy it. They stand behind over $4 trillion in mortgages now....three quarters of all single family homes. The system depends on their solvency and their ability to manage credit risk. Yet the GSEs have managed to distribute that credit risk by making a market in mortgage debt. Attracted by the yield and the implied government yield, trillions in GSE debt sit in the asset columns of balance sheets in both the public and private sector. The financial fortunes of people who may have never heard of GSE ride on the back of the ability of homeowners to make a monthly mortgage payment. No wonder the Fed doesn't want to raise rates.


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