Before the bubble bursts - Fed calls for tighter supervision of GSE's

Thursday, May 19, 2005

Fed chairman Alan Greenspan called for tighter supervision of the Government Sponsored Entities (GSE's) on the grounds that the sprawling growth of mortgage backed securities (MBS) is largely based on the wrong perception of investors that these MBS are guaranteed by the US government. The three industry behemoths Fannie Mae, Freddie Mac and Ginnie Mae have seen their outstanding mortgages grow from one trillion in 1990 to 3.5 trillion dollars last year. Total outstanding mortgages rose from 6.8 trillion in 2000 to 10.1 trillion last year, rivalling the total market cap of US stocks. Daily trading volume in Agency backed securities (ABS) ranged around the quarter-trillion mark in the first two months of 2005 after an annual daily average of 207 billion last year. This is roughly ten times the size of the corporate debt market. In 2000 trading volumes of ABS averaged a mere 69.4 billion per day. This growth rate roughly resembles the growth rate seen in trading of technology (internet) shares on the Nasdaq up to the new millennium. To put this in another perspective, average daily trading volumes in US Treasury debt paper rose from 206.6 billion in 2000 to 497 billion in 2004. For more detailed data, jump to
In his televised speech Greenspan stressed the point that "financial instability coupled with the higher interest rates it creates is the most formidable barrier to the growth, if not the level, of homeownership. Huge, highly leveraged GSEs subject to significant interest rate risk are not conducive to the long-term financial stability that a nation of homeowners requires." This clear warning can be interpreted as a precursor of higher interest rates that could put the huge volume of ABS at risk when interest volatility rises.
40 basis points yield advantage
Greenspan added that the "the government guarantee for GSE debt inferred by investors enables Fannie and Freddie to profitably expand their portfolios of assets essentially without limit.4 Private investors have granted them a market subsidy in the form of lower borrowing rates, which staff at the Federal Reserve Board has estimated at 40 basis points in recent years. This market subsidy is a formidable advantage in our highly competitive Aaa market, where a few basis points are often competitively determinant. Unlike subsidies explicitly mandated by the Congress, the implicit subsidies to the GSEs are initiated wholly at the discretion of the GSEs. They choose when to borrow and gain the advantage of the subsidy, and because markets perceive such debt as government guaranteed, GSEs can effectively borrow without limit."
"Today, the interest rate and prepayment risks inherent in mortgages with a low-cost refinancing option is concentrated in the large portfolios at Fannie and Freddie. These concentrations cannot be readily handled by private-market forces because there are no meaningful limits to the expansion of portfolios created with debt that the market believes to be federally guaranteed," the Fed chairman said.
Crisis mentioned three times
The agencies activities in the secondary market could pose further risk as their portfolios consist almost entirely of MBS. "During a crisis, the GSEs' portfolios of mortgage-backed securities (MBS), in contrast to portfolios of liquid assets such as Treasury bills or cash, cannot provide liquidity to either the primary or the secondary mortgage market. To sell mortgaged-backed securities to purchase other mortgage-backed securities clearly adds no net support to the mortgage markets. GSE portfolios could act as a source of strength to the mortgage markets only if they contained highly liquid, non-mortgage assets such as Treasury bills, which can be readily turned into cash under all possible scenarios without importantly affecting the prices of home mortgages. Indeed, only such highly liquid portfolios would be consistent with the GSEs' mission of providing primary mortgage market liquidity during a crisis, particularly during a financial crisis," Greenspan said.
He opposed the Congress' plans to legislate a mission-only supervision of the agencies and said the GSE's would "need a regulator with authority on par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear. However, if legislation takes only these actions and does not limit GSE portfolios, we run the risk of solidifying investors' perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt." Greenspan had stressed the need for a GSE regulator in his most recent two testimonials to Congress.
The Fed chairman used the word crisis three times in his speech.


Wikinvest Wire