“Gimme a ticket for an aeroplane,
Ain’t got time to take a fast train.
Lonely days are gone, I’m a-goin’ home,
‘Cause my Baby a-wrote me a letter.”
– The Box Tops, “The Letter”
“No criticism can be instructive which is not full of examples and illustrations.”
“Mortgage Securitization Industry“
A letter of concern, transmitted in 4 parts – (Part I)
Dear Mr. Greenspan,
Quoting from your testimony on June 9, 2005:
[Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.]
I would like to submit this respectful disagreement with your assertion. It was at one time very true, but no more. The problems I find with it are centered on the observations of these potential eventualities:
1) – The potential lacking of dependable settlement counterparties [to hedged securitized mortgage instruments, hereafter referred to as CMOs];
2) – The creating of conflicts of interest between the CMO originators and the providers of the very capital that sustain them;
3) – The creating of a tendency toward inappropriate credit qualification by associated mortgage company agents, and thus the resultant misapplication of capital beyond the liquidating net worth of the CMO originators;
4) – The creation of a perceived ad-hoc recommendation by the Federal Reserve Board, according to this statement by its Chairman, of the acceptance of the continuation of excessive [even if hedged] CMO securitizations.
These itemized problems will be addressed in no specific order within the following text:
The securitization of mortgage obligations in the U.S. has been a good thing since its earliest inception. To my current understanding the Federal National Mortgage Association, FNMA, was created specifically as an agency of government because of the dearth of available funds for lending to potential housing buyers during the Great Depression years of the 1930s. It served the function admirably, facilitating the stimulative efforts of a Federal Reserve desirous of inducing capital spending in an era where surviving or recapitalized banks were either hesitant to extend marginal credit, or were hesitant to avail themselves of favourable new reserve requirements, or, without lacking in these hesitancies, did not have the capital available to meet the demand for loans. Often the mortgage lending function of local banks, having the need for funds to facilitate good potential for loan origination business, when its own capital was not sufficient, would face the potential for termination of operations. These circumstances were very conducive to the formation of a securitized mortgages vehicle.
Having the U.S. government back the securitized loans of FNMA thus augmented the lending of funds for the construction of residential housing, thereby giving great stimulus to an industry that either directly or indirectly employed some approximately 20% of the domestic workforce (and still does).
A letter of concern, transmitted in 4 parts – (Part II)
In the normal course of this function, the government, while in theory bearing the risk of default of any single mortgagee, for the greatest part bypassed this risk by selling the now-collateralized securities to the public and financial institutions. By transferring these securities to the public, the agency derived necessary funding, without the need for raising inappropriate investment capital from government. Consequently, the mortgagee needed only know his mortgagor and not the circumstances of the capital that facilitated his loan
When strict measures were implemented to govern the assessment of credit quality of potential mortgagees, then mortgage originators earned their fees in discounts and servicing charges without bringing more than an isolated poor credit risk to FNMA. To do so many times would have quickly caused a given originator to lose his relationship and therefore funding.
Because of the success of FNMA, the government simultaneously created for it the additional purpose of securing Veterans Administration loans (I myself benefited from this) and also decided to divide FNMA into two entities. One, an assumed quasi-government agency, kept the original name, FNMA, but was sold to investors as a stock company and given favourable marginal credit enhancement via its charter of establishment. The other, the newly created Government National Mortgage Association, GNMA, was given responsibility for purchasing, in securitized form but not securitizing them itself, all FHA and VA loans. These two institutions, as we are made to carefully understand now, have distinctly different credit reinforcements available to the investors who buy their individual securities, since in any real comparison no one could doubt the superior credit quality of GNMA securities over all other securitized CMOs.
Doubting this distinction, a doubt the Federal Reserve should have great concern about, would be far again all the worse for the government than it would be for FNMA securities holders, since ostensibly FNMA shareholders, or their securities customers, ought to bear the capital risks which no owner of GNMA securities should. The essence of this distinction compares in a similar way to the difference in granting full tax-free status to many public use-only municipal bonds, while at the same time some quasi-public-use municipal bonds subject the owners to taxation because the bonds carry only tax-free status when not subjecting the owner to the Alternative Minimum Tax. The distinction is because of the purpose of use of funds, often accruing to the benefit of private capital in the case of AMT qualified issues.
Splitting FNMA into the new public FNMA and the dedicated agency, GNMA, made these distinctions in the use of their funds permanent by any reasonable assessment, in my view.
A letter of concern, transmitted in 4 parts – (Part III)
At such time that the new FNMA began to lack the opportunities to find sufficient new capital to fuel the extraction of ordinary EBITDA in a manner that would satisfy its normal aspirations for continued earnings growth, it sought to begin a technique I rather believe was never expected of it by the establishment of its charter. It sought to acquire mortgages and purchase the securitizations of these mortgages itself, for its own investment purposes. It therefore earned not only the normal fees, service charges, or other forms of ‘spread’ from its normal operations, those same operations it was given enhanced credit guarantees for the purposes assigned to it by its original charter, but it also earned a spread between its cost of capital used for the securitizations and the net yield of the resulting securities which derived from them… all this of course net of all forms of risk as well, a not-insubstantial risk I might inject.
In order to protect themselves from one primary type of risk, the threat of fluctuations in securities values resulting from changes in interest rates, they sought to hedge those risks with very complex derivatives contracts, and actions in the open market which set aside either U.S. Treasury fluctuations or reduced the risks attending any leveraging done in taking on these investment securities. The outcomes of these complexities are not as yet known, however it is obvious to anyone that they are by far capable of the almost instantaneous absorption of available liquidated net worth of FNMA. Some expect that the U.S. taxpayer would be called upon at the time to cover losses beyond liquidated net worth.
In addition, in view of the need for FNMA (and all other originators of CMOs) to hedge against inappropriately assumed investment portfolios, they are possibly brought to the occasion of actually working against the interests of the very providers of capital, the public buyers of their securitizations, which provide them their bread and butter.
No, you say?… then make these assumptions with me please, without regard specifically to FNMA, which I consider as being no more than an economic participant pursuing its best interests legally:
-You and I meet on a street.
-I am an originator of CMOs. I have both originated and collateralized three home mortgages from various mortgage companies. I then sell you one instrument and keep two. I have used borrowed funds to margin the two I keep. I am indifferent to your source of funds, although you may leverage as well.
-We say our farewells, glad to have transacted fair business and depart from each other.
A letter of concern, transmitted in 4 parts – (Part IV)
-Shortly thereafter I meet yet a third party on the street, away from your presence, and, being introduced in possibly another manner to the concept that the market for CMOs may be near collapse (marginally), I use the opportunity (possibly in haste, possibly in somewhat frantic nature) to attempt to protect myself and short against the box both my CMOs to the third party, or put on some other hedge, possibly a margined hedge as well. These sales act to depress the market for CMOs, which will cause harm to you, and in many cases that depression of values might just be the result of my failed attempts at ultimately hedging my net spreads.
No one can know if one of these bursts of activity, numerous of which have surfaced during recent volatile trajectories, might trigger a fright among other CMO holders, or other markets, not respecting only those securities held by the two of us. Even still, what if a counterparty I had used for hedging were unable to settle a demand, after a crisis. What then? Would such failure to settle attribute to you negatively, because you had failed to observe my actions outside your view, and failed to understand the nature of my threat imposed on you, my customer in good faith… prior to our transactions?
These are difficult questions and we may wish never to know the answers.
If we may avoid the negatives of my parable of explanation, I agree that the creation of the CMO industry has facilitated and still does facilitate intermediation, rather than hindering it, even if the ordinary availability of capital for securitization is limited during some times. Under those normal circumstances, those of their charter and purpose, I would have no reservations about your statement quoted to begin this writing.
It is also quite likely that constraints on hedged and leveraged securities portfolios of CMO originators would not only give traction to Fed actions to raise long rates (given you intend this which is not my focus), but would necessarily cause prescribed rules governing creditworthiness tests of potential mortgagees to be more carefully observed.
What signal do you wish to send? That the CMO industry is somehow the potential saving grace of a housing industry at threat from excessive activity and prices?… That it would somehow help avoid a crisis, rather than contribute to causing one?
I certainly don’t agree… not now, particularly not when the industry has taken on these additional threats I’ve discussed. I have no means of recommending you raise or lower rates, or that you inject or withdraw liquidity. However, I do certainly have a basis and means of recommending you carefully review the interactions of the Federal Reserve member banks with that most exuberant industry of this discussion, with an eye toward avoidance of crisis.
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