Geithner on Housing -- The Risk Stops Here

At the core of the housing problem was the idea that the risk could be "passed on" to others. Over 25 years, the "passing of the risk" went to such extremes that an extreme over-allocation of capital was directed at the housing market. The new plan, detailed yesterday and today by Timothy Geithner, brings this passing of the risk full circle -- back to the government. Ironically, this is appropriate, in our view, but it is also extremely positive for the markets and taxpayers.

Passing the Risk

The roots of today's problems in the financial markets go all the way back to the housing market and the U.S. government's attempt to create a system that would draw capital to the mortgage market.

The following list summarizes some of the evolutionary steps in this process:

• Fannie Mae is directed in 1981 to purchase mortgages directly from banks and resell them as a single security of a pool of mortgages called collateralized mortgage obligations, or CMOs (usually with a $100 million face value). Fannie Mae issues bonds of its own to raise capital for these purchases, with the U.S. government guaranteeing the interest and principal of Fannie Mae bonds.
  
  This was the first shifting of risk by the U.S. government, as the risk of Fannie Mae failing was shifted to guaranteeing their bonds, implying that the U.S. government would also not permit the failure of any Fannie Mae CMO, not just their bonds.
  
  
• In the 1990s, Congress writes legislation to empower HUD to direct Fannie Mae as to the types of mortgages it must purchase. Over time, this legislative directive increasingly focuses Fannie Mae toward purchasing mortgages from persons lower and lower on the economic scale. This is defined as mortgages for families whose income is below the median income level in that particular neighborhood.
  
  This became the second level of risk assumed by the government, as they allowed banks to shift the risk of default of those mortgages to Fannie Mae.
  
  
• Over time, elements of the Glass-Steagall Act were slowly eroded away, to allow banks to engage in investment banking acts (such as generating their own CMOs, instead of selling individual mortgages to Fannie Mae). Bank of America is perhaps the largest example of a bank that evolved in this direction.
  
  This is another shifting of risk enacted by the government to attract more capital to the mortgage market. Glass-Steagall's core principle was to align short term liabilities only with short term assets and long term liabilities only with long term assets. Allowing banks to create their own CMOs and begin selling them and trading them amounts to aligning short term liabilities (demand deposits) with long term assets (CMOs).
  
  
• As the mortgage market began to explode, competitors emerged to compete with Fannie Mae CMOs. One of the largest of these was Lehman Brothers, from the investment bank side of the financial industry, which eventually bought an entire value chain of mortgage origination and consolidation firms. Washington Mutual was another large generator of CMOs, from the banking side of the financial industry.
  
  In order to be competitive with the "virtual" federal guarantee behind Fannie Mae CMOs, these competitive firms began backing their CMOs with "insurance" from firms like AIG. These competitive CMOs could then be sold as equally secure as the Fannie Mae mortgage bonds.
  
  This was another shifting of risk away from the end holder of a CMO and toward AIG.
  
  
• The final government act shifting risk around was the decision by HUD in the mid-2000s that Fannie Mae could satisfy its legislative obligation to purchase low-income mortgages by purchasing a CMO consisting of mortgages that satisfied the income requirements.
  
  It is this shift of risk that made firms like Lehman Brothers, Washington Mutual, and Bank of America try to gather together as many low-income mortgages as they could. They knew they had a willing buyer who must buy.

The low-income requirement for Fannie Mae is different from the subprime mortgage market, as mortgages that are not subprime could still meet the low-income standards obligating Fannie Mae.

However, mortgages that could be categorized as subprime would also likely meet the low-income requirements of Fannie Mae. How many subprime mortgages were packaged and sold to Fannie Mae so that Fannie Mae could meet its portfolio obligations? We can't find any data to answer this question, but we suspect the number was high.

In April 2008, the HUD directive to Fannie Mae was that roughly 50% of their entire mortgage portfolio must meet the low-income requirements.

(For more on the history of the mortgage market, please see the Ahead of the Curve articles in the archive from last fall.)

Risk Must Live Somewhere

All of these government actions over time were designed to achieve the social objective of making more mortgage money available to U.S. citizens so that they could own a home.

This policy worked fairly well for more than 20 years, particularly during the period when interest rates continually fell, home prices went up, and mortgages were paid off early.

The principle method that the government used to attract capital to the mortgage markets was to shift the risk of holding a mortgage that might default away from the originator of the mortgage and toward someone else.

This shifting was so pervasive that it eventually wound up intensely concentrated in the credit default swap (CDS) portfolio of AIG.

This is why AIG is so central to the current crisis.

If AIG had failed, the dissipation of the risk of default in the mortgage market would have widespread -- and perhaps have destroyed confidence in our entire currency system.

The government's bailout of AIG amounts to a recognition of this possibility, which might have made huge portions of our financial system collapse -- with a resulting loss of bank deposits, not just equity portfolios in a 401(k) plan.

After all, currency is a completely conceptual device for economic exchange. The only thing that makes it work is a faith among citizens that someone else will value a "dollar" in the same way as you do.

The Risk Comes Home to Stay

The Geithner plan to create a public/private partnership boils down this essential concept:

The government has agreed to take on the risk of default in the mortgage market.

By allowing private institutional firms to "partner" with the Treasury and begin purchasing CMOs, the Treasury has found a way to attract capital from firms willing to hold onto -- and not just pass along -- the mortgage pools of CMOs that currently have few buyers.

By limiting the number of these partners, the Treasury ensures that the market prices for CMOs will not "explode" overnight, providing a return over time to these firms that purchase and hold the CMOs until every mortgage in it matures.

The taxpayer -- through the Treasury -- will participate in the return from the purchased CMOs, without having to put real capital upfront. Instead, that return is earned by agreeing to cover future loses, if any.

The core idea behind this partnership is that the private firms that agree to participate in this venture will share in the returns, but the Treasury will insulate them from any capital losses.

The irony behind this idea is that it brings the mortgage market risk full circle and back home to the government.

All of the housing market legislative acts and initiatives designed to attract capital to the market had at their core the idea that risk of bad mortgages could be shifted to someone else.

Now that risk comes all the way back to the U.S. Treasury and the U.S. taxpayer.

The New Partnership

We have long argued that the U.S. Treasury should begin purchasing CMOs with their TARP money, as this would restore the market for CMOs, allowing firms like AIG to recoup the massive amounts of capital they have allocated to loss accounts.

This new idea is even better, frankly, as we think there will be strong competition among financial firms to participate. Private capital will "come to the rescue."

In addition, since CMOs might well trade well below their face value, at even $0.50 on the dollar, the potential for profit is enormous.

After all, it is unlikely that half of all the existing mortgages in the country will fail, which is what a price of $0.50 on the dollar implies.

The only problem has been that you cannot really "see into" the types of mortgages within most of the CMOs. Without knowing whether an individual CMO consists of all subprime mortgages or only a small portion of riskier mortgages, few people were willing to buy them -- which led us to the CMO market collapse in the first place.

But if someone can purchase a large enough portfolio of CMOs, this risk gets increasingly smaller.

Mortgage default rates are currently at the 6-7% level, having risen in the past 18 months from the more "usual" 2% level.

If a CMO can be purchased at half its face value, even if default rates rise to 10% or more, there is still ample room for profit.

Will It Succeed?

We think this plan -- although the full details are still not known -- is the best single idea to have come out as a "solution" since the financial crisis began in the fall.

It might even represent a tremendously good "investment" made by the U.S. Treasury on behalf of the U.S. taxpayer.

After years of trying to find homes for U.S. citizens, the U.S. government finally finds a home for housing market risk.

There is a kind of beautiful irony in this that is likely to go unnoticed by many, but it is comforting that the government has decided not to let "risk" become homeless.

Comments may be e-mailed to the author, Robert V. Green, at rvgreen@briefing.com