2
The Crisis After Subprime
This is a book on pricing an embedded interest rate option in credit derivatives, and there are important parallels to the subprime debacle. The most important of these is that many traders in each market don’t appreciate the fundamental assumptions behind each market. Although this is somewhat of a simplification, subprime mortgages relied on a certain rate of home price appreciation. Similarly, the value of a credit derivative depends on the price of a corporate bond. Credit salesmen and traders seem content to stop here, but a veteran of catastrophe might ask, “Which price, and for what bond?” Valuing the delivery option attempts to answer these questions. The delivery option is a component of around $30 trillion dollars’ worth of outstanding credit derivatives for single-name credit default swaps, according to 2007 International Swaps and Derivatives Association (ISDA) data. While the delivery option does have elements that behave like interest rate options, this type of option goes in the money when a credit event occurs. The largest segment of the credit derivatives market is for corporate debt, but a growing segment is linked to mortgages. The dismal performance and misuse of asset-backed derivative indexes transmitted all of the woes in the underlying market—in this case housing—into the financial markets. The irony is that mortgage credit derivative indexes brought a measure of transparency to a market that might have been better off without it.
This book describes the evolution of a new futures contract based on credit derivatives of the housing-related agencies Fannie Mae and Freddie Mac. (When we refer to “the Agencies” in this book, we refer to Fannie Mae, Freddie Mac, and other housing agencies.) While their assets are of much higher quality than any of those that have run into problems recently, they are nevertheless of the same type. And even though the mortgages held by the Agencies are of very high quality, the Agencies themselves are relatively highly levered, so even small swings in valuation are amplified in the performance of their retained portfolios. In a strange twist of fate, the development of the Agency credit derivative futures contract preceded by a matter of weeks the collapse in the ABX index produced by Markit, a consortium of Wall Street dealers, which signaled the start of one of the worst credit meltdowns in American history. However, understanding the root causes of the problems requires further background on the unique nature of the housing market in the U.S.—which, it’s worth noting, either suffers or enjoys (depending on your perspective) more intense government intervention and regulation than any housing market in any other country in the developed world.
Agencies Born of Crisis
Understanding the Agency market means knowing how the Agencies were created. (The housing Agencies like Fannie Mae, Freddie Mac, and Federal Home Loan Banks are referred to as such to avoid confusing them with nonhousing agencies, such as the Tennessee Valley Authority, which are much smaller and have only minimal retained portfolios.) Franklin Roosevelt created the Federal National Mortgage Association (Fannie Mae) in 1938, in the depths of the Great Depression, to promote affordable housing as a new birthright of every American. The Agency was relatively small and, by today’s standards, relatively uninvolved in the mortgage market beyond a very narrow mandate to help low-income borrowers gain access to mortgage financing. In 1970, to help channel money to the mortgage market, Congress chartered the company that would be called the Federal Home Loan Mortgage Corporation (Freddie Mac). Both entities were conservative and frankly unremarkable until the early 1990s, when the savings and loan scandal severely curtailed the mortgage market for thrifts and local lenders. The market for “local lending” began to erode in favor of a “national mortgage market.” Traditionally, a local lender would originate a mortgage and then hold it as part of its portfolio. Presumably a local bank would have a great deal of information about borrowers and the homes they were purchasing. After the savings and loan crisis it became common to sell certain mortgages to the Agencies, thereby breaking the link between local knowledge and local lending and instead placing emphasis on the easily quantifiable characteristics of a borrower. The door was open to create a national market for mortgage loans, but perhaps not for the better.
In 2003, Freddie Mac was rocked by a scandal of its own, with Fannie Mae disclosing similar problems the next year. In the words of Fannie Mae’s regulator, an agency within the Department of Housing and Urban Development (HUD) called the Office of Federal Housing Enterprise Oversight (OFHEO), former Fannie Mae chief executive officer Franklin Raines used improper “cookie jar” reserves and deferred expenses in order to distort the company’s earnings and to trigger larger bonuses for himself and other top executives.
In the two years after these accounting problems were revealed, the Agencies increased their retained portfolios so much that they became the single largest holders of mortgage securities. In fact, the Agencies had grown to such an extent that their portfolios were temporarily capped so that their accounting could catch up to the changes in their business. At their peak, they together represented $2.2 trillion of the $5 trillion mortgage market.
On the securitization side, the Agencies were gobbling up most of the mortgages produced in the country, crowding out traditional investors like thrifts and regional banks. The existence of the federal Agencies alone wouldn’t have been enough to crowd out private firms. However, Fannie Mae and Freddie Mac are structured in ways that have given them significant competitive advantages over other companies.
By statute, Fannie Mae and Freddie Mac are allowed 40:1 leverage (although neither has ever reported leverage quite that high). This means that their debt-to-equity ratio is skewed so that $1 in equity can control up to $40 in debt. The typical bank, on the other hand, is only levered around eight to ten times. The advantage of higher leverage is that pricing discrepancies and potential profits or losses are amplified up to forty times for the Agencies and only up to ten or so times for fully private companies. So, if the market presents an opportunity to earn $1, the more highly leveraged Agencies might only have to hold $0.025 against that trade, while a commercial bank might hold $0.10, allowing the Agencies a far higher rate of return. Put another way, the Federal Reserve would never allow a commercial bank to operate with the kind of leverage that the Agencies routinely employ, and the leverage advantage of the Agencies has been well cemented in the regulatory framework of the financial system.
Leverage isn’t the end of the story. The Agencies also enjoy a funding advantage. It is cheaper for them than for other companies to raise money because the market believes that Agency securities come with government guarantees. The perception is that investing in Fannie Mae and Freddie Mac securities is almost as low risk a proposition as investing in Treasury securities. This means that the Agencies can raise money on terms that are almost as favorable as those of the U.S. Treasury. According to their federal charter, the U.S. Treasury is officially allowed to purchase up to $4 billion in short-term debt, which gives the Agencies a lifeline should they run out of short-term funding. Compared to the size of their retained portfolios, this $4 billion lifeline is woefully small. However, the fact that it exists has historically afforded the Agencies a funding advantage. In 2008, Treasury Secretary Paulson was granted authority to invest hundreds of billions more into the Agencies. Although they can’t borrow at exactly the same rate as the U.S. government, they can borrow more cheaply than any private company because of this lending facility by the Treasury.
If responsibly used, this combination of funding advantage and leverage could be the right tool to get more people into affordable housing. However, the Agencies have been given an authority that turns this story somewhat negative: they are able to help define the size of the loan that constitutes a “conventional” or conforming mortgage. (Loans are said to be conforming when they meet the Agencies’ qualifications, and are subsequently approved by OFHEO.) At the end of 2006, the conforming-loan limit stood at $415,000. A loan of this size would have to be combined with about $100,000 in equity to meet the 80 percent loan-to-value requirement, which means that the Agencies are helping to finance some half million-dollar houses! In 1938, Franklin Roosevelt described his motivation for establishing Fannie Mae: “I see one-third of a nation ill-housed, ill-clad, ill-nourished.” It is impossible to imagine that President Roosevelt ever intended to provide government assistance to people buying half million-dollar McMansions.
Originally, Fannie Mae was part of the government-owned Reconstruction Finance Corporation, which had the mandate to buy Federal Housing Administration loans. In 1948 the Agency began buying Veterans Administration mortgages to ease the troops coming back from World War II into home ownership. In 1954, Fannie Mae was rechartered as a public-private mixed-ownership corporation; the idea in fostering private participation was that the discipline of the market would help the firm better fulfill its original mandate. Ironically, FDR had created Fannie Mae because of the perception that the market had failed to create an adequate supply of affordable housing. It only took the politicians sixteen years to stand Roosevelt’s guiding principles on their head. Created to solve a failure of capitalism and stand outside the private market, the Agency would become part of the very system whose deficiencies had motivated its creation.
Politicians sought to resolve this conflict in 1968. They divided Fannie Mae into two companies, one public and one private. The public company, Government National Mortgage Association, also known as Ginnie Mae, retained the explicit backing of the government. The private company, Fannie Mae, was intended to be indistinguishable from any other private company except for its federal charter and a line of credit with the U.S. Treasury (there were also a handful of distinct characteristics relating to the registration and tax status of its debentures). Of course, a line of credit with the government is no small thing, as became apparent decades later.
In the 1970s, interest rates rose and Fannie Mae’s profits declined, but there weren’t any indications of just how far the Agency had strayed from its affordable housing mandate until the early 1990s. In 1991, Fannie Mae CEO David Maxwell retired with a $29 million pension package, sparking an outcry from some lawmakers that Maxwell’s pension had come at the expense of the federal government. By this time, Fannie Mae and Freddie Mac’s lobbyists were among the most influential in Washington D.C., and they were part of a fabric of corruption that OFHEO would call in its $400 million accounting settlement with Fannie Mae in 2006 an “arrogant and unethical corporate culture.”
Contradictory Objectives?
The Agencies’ mandate pulls them in two opposing directions: On the one hand, they are directed to promote affordable housing by making risky loans; on the other hand, they are instructed not to take too much risk. In order to decrease the risk of loss on a loan portfolio, a lender lends only to the most creditworthy borrowers. This usually eliminates low-income borrowers, the ones who need loans—and affordable housing—the most.
In 1999, government regulators began investigating whether or not the Agencies’ automated underwriting systems were racially biased. The next year HUD released a report indicating that low-income neighborhoods were poorly served by the Agencies. By this time, low-income urban areas had become predominantly minority enclaves because higher-income white borrowers had fled to the suburbs. Concerns that the Agencies were contributing to the racial polarization of America sparked numerous local investigations. In response to the HUD study, Fannie Mae first eased credit requirements hoping to boost minority homeowner-ship and then, in 2000, announced that it would make $2 trillion in loans to low-income minority buyers. As expected, this announcement inspired criticism that such a program would expose the Agency to high-risk buyers, thereby jeopardizing the loans the Agency had already guaranteed. It seems that there is no middle ground possible for public-private institutions whose mandate is to maximize shareholder value at the same time that they serve a need that no other private enterprise seems willing to fill. The larger the Agencies became, the more difficult it was to find a happy medium between profitability and the high-minded goals with which the entities began their life.
The Golden Goose
As the Agencies changed, so did Wall Street.
When Fannie Mae and Freddie Mac decided to increase their retained portfolios, which together reached $1.5 trillion in 2003, they simultaneously bought mortgage securities and sold debentures, and hedged the interest rate and convexity risk between the two with derivatives like interest rate swaps and swaptions, which are options on swaps. This became increasingly profitable to the securities dealers who handled the transactions. Moreover, the Agencies had relatively little equity behind these transactions. As explained above, small discrepancies in the risk between their assets and liabilities would be amplified by as much as forty times. Given these high risks, the Agencies were quite active in their trading of interest rate derivatives. At one point prior to their accounting meltdown in 2003, they were likely the largest single clients of every major firm on Wall Street.
Their growing influence on Wall Street did not go unnoticed at Freddie Mac and Fannie Mae, and they wielded their clout quite effectively. They insisted that their corporate debt be traded by the Treasury trading desks, rather than being lumped in with corporate debt from private companies. Although they didn’t realize it at the time, this move prevented their debt from eventually sharing in the explosive development of the credit derivatives market for corporate debt, hurting them in the long run.
The motivation of the Agencies was straightforward enough: if their debt was perceived to be akin to Treasury securities, they could borrow at lower interest rates than a private company, thereby increasing the margin between their assets and liabilities. They increased their retained portfolios by purchasing mortgage securities with money borrowed through their debentures, collecting the difference in yield between the two. The lower the borrowing cost of their debentures, the more of the mortgage interest they would keep.
In fact, encouraging the perception that Agency debt was as safe as Treasury debt became so central to the business models of the Agencies that it was part of their marketing road shows in the late 1990s, when they were promoting Agency futures at the Chicago Board of Trade (CBOT). The concept they were selling was simple: as the Treasury reduced the supply of bonds and notes outstanding, where was the bond market to look for the new benchmark? It would greatly benefit the Agencies if the market decided that Agency debentures should be the new standard reference rate. The Agencies established a regular issuance calendar reminiscent of the Treasury auction schedule. They helped launch futures contracts based on their debt. These contracts had the same characteristics as the wildly successful contracts based on Treasury notes and bonds.
The Agencies wanted to avoid the ascendancy of interest rate swaps as the benchmark in the fixed-income market. As it turned out, neither interest rate swaps nor Agency debentures wrested the mantle of “most important reference security” from the Treasury market, and the budget surpluses that led to the repurchase of outstanding Treasuries were short-lived. In late 2001, the U.S. entered a recession and the supply of Treasury debt began to rise, dashing hopes that Agency securities would become the new benchmark asset class.
The Agencies were left with a regular issuance calendar and a financing market that never gained critical mass. Part of what makes the Treasury market so efficient is the ability of traders to sell issues short and borrow securities in the repo, or financing, market. Securities without developed repo markets are impossible to sell short. Betting in these markets is asymmetrical, with traders either long or not long on a given security. Consider what an awkward position the Agencies put themselves in with their regular issuance announcement: whether their debt was rich or cheap, they now had to come to market on a set schedule, just like the U.S. Treasury. Developing a repo market depends on regular issuance, which allows traders to know when the new supply will be added to the general collateral pool. Without regular issuance, each particular issue may trade at a distinct repo rate and become increasingly expensive for the short to borrow.
Regular issuance certainly aids in developing a repo market. However, it is an expensive proposition. Normally companies issue debt because they have a specific need or they feel that they have an opportunity for an inexpensive source of capital, and their debt is rich in some way. Issuers treat this decision opportunistically, but what does this mean for the buyer of debt? If the issuers are right, and their debt is rich whenever they come to market, it is a bad deal for the buyer. The point of creating a regular schedule is to level the playing field. By doing so, the issuers of debt admit that occasionally they may come to market at a time that is more expensive for them than they would like. What they’re hoping for is a long-run reduction in the risk premium associated with their debt. As the largest financial institutions in the U.S., and the second-largest issuers of dollar-denominated debt after the U.S. Treasury, the Agencies were often in a better position to judge whether or not their debt was richer than the rest of the market. Giving up the ability to pick and choose the timing of future issuances was a major gamble for the Agencies, and one that never paid off.
Losing Focus
Between the late 1990s and early 2003 the Agencies lost focus, maintaining a system of regular issuance even though they had abandoned hope of becoming a benchmark in the market. The risk premium in Agency debt never evaporated, even with regular issuance, and it was not clear what the preceding work to achieve benchmark status had achieved.
Having failed in their objective, they had no clear mandate going forward. The Agencies wanted to continue to grow, but in fact their potential for further growth was probably limited without the significant drop in funding costs that would have come if they had achieved benchmark status, at which point risk premiums on their debentures would have evaporated. In the few years between the late 1990s and 2003, Agency executives must have been under enormous pressure to achieve financial targets—even after it was clear that they wouldn’t succeed in gaining any benefit from the economic mechanics they had once hoped to engineer. Hints of this pressure came to light in 2003, when Freddie Mac first revealed accounting irregularities. In the fall of that year, during the federal probe, vice president of asset liability management Mustafa Chowdhury and several other people left Freddie Mac, as was reported in an October 28, 2003 Bloomberg News story by Al Yoon. As the investigation unfolded, it was clear that the discrepancies ran into the billions of dollars.
Perhaps it was good luck for the Agencies that their non-compliance with generally accepted accounting principles was discovered during a time when they were doing well. Imagine the chaos that would have ensued had their problems been revealed in March 2008, at the time of the shotgun wedding between Bear Stearns and JPMorgan Chase. As it happened, the Agencies’ mispricing of securities hid a multibillion-dollar gain. Traders all across Wall Street acknowledged the shortcomings of the Agencies, but then immediately said, “Yeah, but ... they actually made more money than they reported.” The common spin had it that hiding earnings was somehow better than hiding losses. Unfortunately, the only reason to hide earnings is to subsequently hide losses; the two acts are inextricably linked and equally wrong. As time went on, the extent of what only the most charitable would describe as accounting “irregularities” became clear. Several years’ worth of financial statements needed to be revised. While the press was digging into Freddie Mac, its larger competitor, Fannie Mae, was noticeably silent on the matter of accounting and oversight.
Early the next year, Fannie Mae announced that it suffered from the same accounting problems that had snarled Freddie Mae. The subsequent investigation led to an order that Fannie Mae restate several years of financial statements and cost the Agency approximately a billion dollars in legal and accounting fees.
Nearly seven decades after their establishment, with the best of intentions, during the Great Depression, the Agencies weren’t spending a billion dollars on affordable housing; they were spending a billion dollars on trying to do the accounting for affordable housing. As with many government operations, the bureaucracy itself had become a greater problem than the problem it was created to solve.
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