Your silver child
suspended in space
Crying out
to you
Beckons you
to yet another fine place
Where the trials of
life are few

Don't think you're living long
Who says you are coming on
They won't remember you
The rent is always due

Neil Young

 

Yesterday our colleague Chuck Gabriel at CapitalAlpha Partners in Washington put out a research note indicating that the Obama Administration has decided to support a two-year extension in the conforming loan limit for Fannie and Freddie.

 

As we have noted in past comments, the limit on loans that can be guaranteed by the GSEs is set to fall back to pre-crisis levels at the end of September. Loan markets around the US have already begun to seize up in anticipation of the change.

 

But while this eleventh hour fix is good news of sorts, it does not change the fact that the Obama Administration and most of the federal regulatory community have badly botched the government's response to the mortgage crisis. Part of the issue is a lcak of understanding of the problem, but mostly it is the big banks and GSE continuing to exercise their cartel pricing power to deny American home owners their legal right to refinance.

 

Let's review the history so we can all get on the same page. In 2002, when the Fed dropped interest rates dramatically after the banking industry and markets went into a stall, the mortgage markets saw a wave of home refinancings. This is precisely what the Federal Open Market Committee wanted to see happen; liquefy households and boost consumer demand.

In response, the GSEs started to accelerate their purchases of private label securities ("PLS"), buying the "AAA" pieces of PLS to help to maintain the yield on their retained portfolios. Remember that a decade ago, we were still pretending that the GSEs were private corporations and their officers were busy enhancing earnings to build their bonus pool.

 

Paul Krugman, Bob Kutner and Frank Portnoy, among others, are right when they say that Wall Street's greed drove the mortgage debacle. But they forget that Fannie Mae and Freddie Mac were considered part of Wall Street until the collapse of Lehman Brothers and Bear Stearns in 2008. You cannot separate the private and public sector contributions to the crisis; it was a true partnership, but one that starts with the government intervention in the housing sector with the New Deal.

 

While the GSEs were buying all of that "AAA" rated PLS paper from the Wall Street dealers for the retained portfolio, the inferior tranches went to fuel the CDO machine, paper that was eventually bought by EU investors. While liberal commentators still argue that Wall Street and not their beloved New Deal agencies caused the crisis, the fact is that those CDO deals built on "A" through "BB" tranches would never have been done without the GSEs providing a ready market for the "AAA" rated tranches.

 

The surge in prepayments in 2002 drove the banks and GSEs to loosen their criteria in order to generate new, high spread at time of origination or SATO loans to replace the RMBS in portfolio that were seeing very high prepayment speeds. This decrease in credit quality at banks and by the GSEs had the same motivations, namely greed. But, again, it is impossible to separate the role of the government and the private banks in creating this mess. The two constituencies were locked in a loving embrace that went on for years and with the full connivance of both political parties in Washington.

 

In 2008, when the Fed again dropped interest rates to liquefy households and boost consumer demand, the GSEs responded by raising the barrier to home refinancing by changing the loan level pricing adjustment or LLPA. This move defeated the Fed's LSAP program to purchase mortgage securities and thereby drive a significant increase in home refinancing. Rich people got refinancings, but the vast majority of Americans how had the legal right to refinance in 2008 and 2009 were locked out by the banks and the GSEs, who did not want to see the high coupon, high SATO loans produced between 2002 and 2007 prepay. Again the reason, greed, both by banks and the GSEs.

 

Remember that the biggest holders of these RMBS are the GSEs themselves and the Fed, followed by banks and private investors. But because of the actions of the GSEs to prevent Americans from exercising their legal right to refinance, the holders of the high coupon securities have been overpaid for years.

 

Hundreds and hundreds of billions of dollars worth of Fannie and Freddie securities should have prepaid years ago, but instead the GSEs and other holders of these securities have been receiving above-market yields on their investments. This is not only unfair to American home owners, but it also means that the US economy is not going to recover until the government forces the GSEs to change their LLPAs and aggressively start to refinance these high SATO loans.

 

Senator Barbara Boxer (D-CA) has introduced a proposal to force the GSEs to refinance the loans in their portfolios as well as in pass through securities. The Obama Administration has finally put forward a proposal to force trustees of private RMBS to allow principal reductions on mortgages to help keep up to 1 million people in their homes. Both of these initiatives are important and necessary for the US economy to recover. But both proposals also represent a deliberate government-mandated default on these debt instruments. So much for the arguments about raising the federal debt ceiling that rely on the need to avoid default.

 

In the event, this new wave of refinancings will mean a massive prepayment to the GSEs and to private investors, who have been free riding at the expense of home owners and the American economy. A broad program of refinancing will make the losses at Fannie and Freddie soar and will reduce the cash flow going to banks and other investors in GSE paper. It is likely that several large financial institutions will be forced into a Dodd-Frank restructuring when the government rips away half of their net interest margin as a result of prepayments on vintage RMBS.

 

These two proposals will be very bad for the support of bond owners of PLS for future participation in the mortgage market, but senior bond holders will likely do much better. The Boxer and Obama proposals are probably good for loan servicers too as they are first in line to get repaid servicing advances when the loan is sold. This is a "servicer safe harbor" issue, but the larger economics are always better for all investors on a short sale or modification than a long drawn out foreclosure process.

 

But shed no tears for holders of private RMBS. The excess spread that these investors have been receiving because of the GSE efforts to block home mortgage refinancings for the past three years more than compensates for the lower yields they will receive when the proceeds of prepayments are reinvested at today's market rates. Strange as it may seem, we support the Boxer proposal. Indeed, we suspect that Senator Boxer may have been reading the work of our friend Alan Boyce, head of the Absalon Project.

 

For the past three years and more, Boyce and other member of our Berlin-Los Angeles axis of understanding have been trying to educate members of Congress and other inhabitants of Washington as to the reality of the GSE-bank mortgage market cartel. In particular, Boyce has focused on how the GSEs and the largest banks are actively seeking to prevent Americans from refinancing their mortgages -- and at the same time thwarting the Fed's efforts to stabilize the economy through QE.

Click here to see the latest version of Alan's presentation. Note particularly Page 13, which shows that high income home owners who could qualify for the tighter LLPAs put in place by the GSE's in 2008 were twice as likely to refinance as lower income borrowers. The bottom and lower middle income households with high SATO loans are precisely the mortgages that the GSEs and banks own in their portfolios.

"Now that it's the one year anniversary of Dodd-Frank, there has been lots of discussion on what should be done in the future," Boyce notes, "but no discussion of what is happening on a daily basis."

Bottom line: If the Obama Administration wants to see the US economy recover, then we must start the real process of restructuring that Washington & Wall Street have been avoiding since 2007. President Barack Obama may not be able to turn things around before the 2012 election, but he will be remembered more kindly in the history books if he has the courage to do the right thing. As always, we are available to help in this process as and when somebody in the White House or Treasury wants to pick up the telephone.

 

 

(c) Institutional Risk Analyst

www.institutionalriskanalytics.com

 

 

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