MFIN7012 Part 4: US Mortgages and Securitization;
the Modern Financial Alchemy
October 9, 2009
1. The US Mortgage Market
– 1.1. US mortgages
– 1.2. The Mortgage Federal Agencies
– 1.3. The “Fed Experiment” of 1979; the Savings and Loans (S&L) Crisis
– 1.4. Risks in the MBS market
– 1.5. The MBS market
2. The Modern Financial Alchemy - Credit Derivatives
– 2.1. Credit Default Swaps (CDSs)
– 2.2. Collateralized Debt Obligations (CDOs)
– 2.3. The Credit Derivatives Market
3. Recent Events and Issues in the Credit Markets
– 3.1. The “Subprime Crisis”
– 3.2. Market breakdown
– 3.3. Some history on the Investment Banks
– 3.4. Some Theories of the Crisis
– 3.5. Last words
1. The US Mortgage Market
1.1. US mortgages:
– US style mortgages are usually ﬁxed rate, and the holder has the right (the “pre-
payment option”) to pay oﬀ the outstanding principal at any time, calculated on
the basis of the amortization schedule (see Tuckman Table 21 1.xls) correspond-
ing to the ﬁxed mortgage rate.
– Thus if interest rates fall, the mortgagee can reﬁnance - prepay the mortgage, and
then take it out again, at a lower rate.
– This is very convenient to the mortgagee - but “option theory” is required to value
the mortgage correctly.
– (In contrast, HK mortgages are usually ﬂoating, based on a ﬂoating “prime rate”, one
suspects for the convenience/beneﬁt of the lender.)
• (There is also the “default option”, of which more later.)
• Saving and Loans (‘S&L’s, or ‘Thrifts’):
– Before the 1980’s, US homeowners would get a mortgage from their local S&L.
– The S&L’s funds were provided primarily by bank accounts.
– The ‘3-6-3 rule’ - borrow at the short rate of 3%; lend at the long rate of 6%, and
play golf at 3:00 pm.
– Maturity mismatch! - OK if the long rate is higher than the short rate (which it
– More recently, you can get a mortgage from a bank, insurance company, pension
fund ... (“deregulation”).
– The originator of a pool of mortgages can keep them on its own books, or “secu-
– - i.e. issue a Mortgage Backed Security (MBS), which entitles the holder to receive
the mortgage payments.
– Securitization has been encouraged by the Government, as a way to make capital
more readily available for housing.
– The S&Ls which originated the mortgages continue to service them.
1.2. The Mortgage Federal Agencies:
– The Government has sponsored several Federal Agencies which stand ready to buy
∗ Government National Mortgage Association (“Ginnie Mae”).
∗ Federal Home Loan Mortgage Corporation (“Freddie Mac”).
∗ Federal national Mortgage Association (“Fannie Mae”).
– These are allowed to accept MBS, so long as they be “conforming” to various rules,
which are diﬀerent for each agency.
– For example, the underlying mortgages cannot be too big (otherwise they are
– Also, the borrower must pass creditworthiness criteria (otherwise they are “sub-
– The agency then bundles the the MBS into standard forms, and sells them to the
– Thes standard forms include various guarantees of timely payment, even if the
mortgagees do not make timely payments.
• Government guarantees on the Agency MBSs:
– Text books say that the Ginnie Mae MBSs are explicitly guaranteed by the Gov-
ernment, but Freddie and Fanny MBSs are not.
– But the market has assumed that Freedie and Fanny, and their MBSs, had de-facto
guarantees, in the sense that the Government would not allow them to fail.
– (“Too big to fail.”)
– The market was right! - Fannie and Freddie were nationalized in 2008, to prevent
failure of their MBS products (see later).
• “Nonconforming” mortgages:
– can also be turned into MBSs, but not by the Federal Agencies.
– They are sometimes called “Private Label” MBSs.
– But they will not have the Government guarantee, and so will have a higher yield
• (Also in the Universe of Federal Agencies:
– The Student Loan Marketing Association (“Sallie Mae”),
– Farm Credit Financial Assistance Corporation,
– Resolution Trust Corporation - an S&L “bad bank” see later.)
1.3. The “Fed Experiment” of 1979; the Savings and Loans (S&L)
• The Fed Experiment:
– Paul Volker became Fed Governor in 1979 - tasked with squeezing inﬂation out of
– “The next Fed Chairman will have to be very tough” - Paul Volker in his job
interview, with President Jimmy Carter.
– He announced that the Fed would target money supply, not interest rates.
– Interest rates became very high, and the term structure became inverted - see the
– After 2 years Volker felt that the economy had been punished enough, and interest
rates started coming down.
• The S&L Crisis:
– S&Ls became extremely distressed, owing to the maturity mis-match - borrow short
(high!); lend long (low!).
– Many sold their entire mortgage portfolios to investment banks, lead by Salomon,
– ... at ‘distress’ prices - only the investment banks knew enough option pricing
theory to price and hedge them correctly!
– (The modern solution for the maturity mis-match would be to do a maturity swap
- but these were not available at the time.)
• Government bail-out (mid 1980s):
– The Government eventually set up the Resolution Trust Corporation, which bought
“toxic” mortgages from the S&Ls.
– Total cost estimated at $200 billion.
– The Deposit Insurance of Part 2, page 15, was also part of the bail-out.
1.4. Risks in the MBS market:
– To analyse prepayable mortgages, we can use options theory - see later in the
– Brieﬂy, the prepayment option is similar to the call option in a callable bond.
Exercise the option when the underlying bond price rises, i.e. when the interest
– But in reality, it is not as simple as this!
– Since most mortgage holders are not ﬁnance professionals, they do not always act
rationally according to option theory!
– Also, they might have other reasons to prepay the mortgage - for example, they
might want to sell the house, or they might have had a windfall ﬁnancial gain.
– See Tuckman, Figure 21.1, for the likely market price of an actual mortgage (a
‘pass-through’), versus the theoretical price of the corresponding non-prepayable
– The default option is that the mortgage holder can walk away from the obligation
represented by the mortgage.
– In this case, the mortgage provider is legally entitled to sell the property.
– (Default has not been considered a problem for the “Pass Throughs” issued by
the Federal Agencies, because they have been assumed to be guaranteed by the
– (Default is a problem for the agencies themselves, and for buyers of “private label”
• These facts make the trading of these mortgages very tricky; Wall Street devotes much
eﬀort to guessing how mortgage holders will behave.
1.5. The MBS market:
• Investors can buy the MBS described above.
– The Feredal Agencies have their standard “pass through” products, with guaran-
– The Private Labels have their own products, derived from the “non-conforming”
mortgages, and which are not guaranteed.
• The pass throughs can be further “sliced and diced” to create derivatives, eg the MBS
IO (‘interest only’) and POs (’principal only’) “STRIPS”:
– ( - not to be confused with the Treasury STRIPS.)
– The IO pays only the interest on the pool of mortgages, and the PO pays only the
– So if a mortgagee prepays, then his (indirect) payments to the IO holder cease, and
his principal payment goes to the PO holder.
– The PO value increases when interest rates fall, for 2 reasons: First, mortgagees are
tempted to repay when rates fall, and the principal payments are thus accelerated.
Second, the discounting eﬀect is less when rates fall, making the PO even more
– Complementing that of the PO, the value of the IO falls dramatically, when rates
– See Tuckman, Figure 21.2.
• Credit enhancement (for the non-agency “private label” MBSs):
– The MBS issuer might be able to get an AAA rating from Moody’s.
– The MBS issuer might buy third party guarantee/insurance (see CDSs, later).
– The MBS issuer might issue a CMO (Collateralized Mortgage Obligation).
∗ This is “tranched” structure of securities, with diﬀerent seniorities, based on
∗ If any mortgage prepays or defaults, then there is a corresponding to a reduction
of the principal.
∗ This payment and/or principal reduction is allocated to the most junior tranche,
until the tranche itself has zero principal.
∗ The senior tranches are thus considered unlikely to suﬀer, and can often get an
∗ (See also Collateralized debt Obligations (CDOs), later).
– These credit enhancement techniques have recently been problematic More detail
1.6. Current issues in the US mortgage market:
• Securitization and beyond:
– The system of MBS Securitization, described above, is well established, in the
textbooks, and seems to have worked well.
– But the “modern ﬁnancial alchemy”, discussed below, takes the market to a new
– The above paragraph “Credit enhancement” is a preview of this.
– The “subprime crisis” - see later...
• Who Is ultimately ﬁnancing US mortgages?:
– i.e. Who is holding the MBSs?
– “Conﬁdentiality rules” - we don’t exactly know!
– According to the securitization theory, the ultimate investors are the parties “most
willing and able to bear” the risks.
– The most optimistic about the housing market!
– (The biggest fool in the market?)
– The holders seem to be the banks, hedge funds, pension funds - not just in the
2. The Modern Financial Alchemy - Credit Derivatives
2.1. Credit Default Swaps (CDSs):
– This is one of the important innovations of the last few years.
– Its purpose is to provide insurance against default of a bond.
– If I hold the bond, then I can enter the CDS, and pay a ﬁxed amount every year,
say 0.9% of the principal to the CDS counterparty.
– If the bond defaults (“there is a credit event”), then I can claim the insurance as
in the CDS contract.
– The contract might say that I can sell the bond to the counterparty, who has to
pay the face value of the bond.
– Or it might be cash settled - the counterparty pays me the face value minus the
– After the credit event, the swap payments cease.
• Analyzing CDSs:
– Theoretically, the swap payments are just the same as the “credit spread” on the
bond - extra interest that must be paid since the bond is not riskless.
– To value the CDS you have to estimate the probability of default, and the likely
recovery rate, if the bond defaults.
– This is tricky! - more tricky than estimating volatility, because default is a rare
– On the other hand, it is theoretically the same as pricing the bond.
Moral hazard in the CDS market:
• Erosion of diligence:
– if I buy a bond, then I am lending money to a company, and I have an interest in
the conduct of the company.
– I might have to work to ensure that bond covenants are adhered to, etc.
– But if I have also done a CDS, then I don’t care if the company defaults.
– Default is the problem of the CDS counterparty and he will ﬁnd it more diﬃcult
to inﬂuence the company.
• Betting on default:
– The CDS is similar to an insurance contract - above, I am “buying protection”
(“insuring myself”) against default of the bond.
– What if I buy protection, when I do not own the bond? - this is similar to short-
selling the bond.
– Is this allowed? - YES!
∗ CDSs are not legally treated as insurance. (Note that it is illegal to take out
insurance on something that you do not own.)
∗ And they are not subject to restrictions that might apply to short-selling, i.e.
that you have to borrow the underlying, to short sell it.
∗ In fact the credit market has largely been unregulated - see later.
– “Bear raids” - buy the CDS and spread rumors about the company.
– Recently, the outstanding volume of CDSs on General Motors (GM) has been many
times the outstanding volume in the underlying GM bonds!
– See FT article, February 2009, “Hidden agendas...”
2.2. Collateralized Debt Obligations (CDOs):
(See Lucas, Goodman and Fabozzi, “CDOs and Risk Transfer”, Yale International Center
for Finance (2007) - http://ssrn.com/abstract=997276)
• A CDO is an investment vehicle, which takes a portfolio of assets, and structures the
liabilities into a subordinated set of “Tranches”. For example:
– Assets might be a portfolio of corporate loans, or MBSs.
Tranche Percent of capital structure Rating Coupon
A 77.50 AAA LIBOR + 26 bpt
B 9.00 A LIBOR + 75 bpt
C 2.75 BBB LIBOR + 180 bpt
D 2.75 BB LIBOR + 475 bpt
Equity 8.00 NR (Residual cash ﬂow)
∗ Tranche A is the most senior - payments to Tranche A must be completed as
contracted, before payments to Tranche B can be made.
∗ These tranches are given ratings by the Ratings Agencies.
∗ “Credit enhancement” - Tranche A might be AAA rated, even if the assets are
not highly rated. This is because there has to be a lot of default, for Trance A
to be aﬀected.
∗ And “a lot of default” is assumed to be unlikely - this argument relies on the
correlation between defaults not being too high.
– Credit structures:
∗ “Waterfall of cash payments, starting from Tranche A.
∗ Rules about paying down Tranche A, if lower tranches are not being paid, etc.
Purposes for the issuer (according to Lucas, Goodman and Fabozzi):
∗ - by which they mean that the managers want to ﬁnance their purchase of the
∗ The “arbitrage” is to gain from their presumably superior ability to manage
– “Balance sheet” / “regulatory arbitrage”:
∗ - the holder of the assets wants to get them oﬀ his balance sheet.
∗ This might be to conserve the need for regulatory capital.
∗ The CDO is put into a Special Purpose Vehicle (SPV), also known as a Special
Purpose Entity (SPE) or Special Investment Vehicle (SIV) , which is eﬀectively
a separate company.
∗ The SPV is supposed to “bankruptcy remote” from the originator - if the SPV
fails, then the originator does not suﬀer.
∗ The originator might be required to keep the equity portion, to ensure that he
will be diligent.
– (Were the SPVs really bankruptcy remote?:
∗ When the SPVs began to fail, most banks agreed to take them back onto the
balance sheet - so they should not have been “oﬀ balance sheet” in the ﬁrst
∗ Taking the SPVs back seems to have been compelled by a legal judgement.)
∗ - to raise money for new investment, in eg property (REITs).
• Related structures:
– CMOs - “Collateralized Mortgage Obligations”. The underlying assets are MBSs,
rather than bonds.
– CDOs of ABSs - “CDOs of Asset backed securities”. (An ABS is a generalization
of an MBS.)
– “Synthetic” CDOs, whose assets are not bonds or ABSs, but CDSs. Since a CDS
does not have an up-front cost, then a synthetic CDO does not have an up-front
– CDOs of CDOs (also known as CDO2 ’s, or “Russian doll” CDOs). (I think these
were to much for the market, even when they were ﬁrst issued.)
Valuation, risk assessment and rating of CDOs:
– Need a model - use Monte Carlo simulation!
– Extremely tricky - “it might take a whole weekend to value the CDO”! See FT
article, 10 March, 2009.
– Need to estimate the probability of default, of the underlying assets.
– Also need the correlation of default - if the correlation is high, then Tranche A
above might not warrant being AAA.
• Risk assessment and rating:
– Buyers of the CDOs want them rated (Moody’s AAA, etc), and might not be
allowed to buy them if they do not have a high rating.
– So the issuers ask Rating Agencies (Moody’s etc), to rate them - and the issuers
pay for this.
– The investors have tended to trust the agencies rating - see FT article, 3 March
– The agencies have to use a model - what if the model is wrong?
2.3. The Credit Derivatives Market:
• Motivation for trading credit derivatives:
– Buyers of credit protection (“insurance”/“credit enhancement”):
∗ Banks making loans, can reduce the credit risk, without oﬄoading the loan,
and thus keep the relationship with the client.
∗ Pension funds and mutual funds might need to restrict themselves to highly
rated bonds - buy senior CDO tranches.
∗ Why not just buy Treasury bonds? There are not enough of them! (Also they
have a lower yield - more expensive - see “yield enhancement” below.)
– Credit protection sellers:
∗ Players clever enough to manage the risks - for example AIG wrote CDSs, on
the basis that they were insurance. (See FT article, 4 March 2009.)
∗ Players clever enough to construct CDOs - the Investment Banks!
– “Yield enhancement”:
∗ The AAA tranche of a CDO, or an insured bond, will be (supposedly) almost
riskless, but will have a higher yield than a Treasury bond.
∗ This is what we mean by “alchemy”.
• How big is/was the market?:
– From a small base in 2000, the CDS market grew to a volume outstanding of $ 60
trillion, at its height in 2007.
– This is BIG - equal to the output of the entire world!
– (But this ﬁgure does not count netting - with netting the outstanding might be $
– CDOs - see FT graph, 10 march 2009.
• Who are the credit protection buyers and sellers?:
Banks 38% 51%
Securities houses 16% 16%
Hedge funds 15% 16%
Corporates 2% 3%
Mono-line/re-insurers 17% 5%
Insurance companies 3% 2%
Mutual funds 4% 3%
Pension funds 4% 3%
Gov/Federal agencies 1% 1%
(Source: British Bankers Credit Derivatives survey, 2003 - 2004.)
3. Recent Events and Issues in the Credit Markets
3.1. The “Subprime Crisis”:
• Beyond securitization:
– The technology of credit derivatives super-charges debt markets.
– As it applies to mortgages, the Credit Derivatives market can be regarded as pro-
viding an extension of “securitization” in the mortgage market.
• Recent practice in the Mortgage markets (“originate and disperse”):
– Originate mortgages, which can be ’‘subprime”, i.e. the borrower presents some
(presumably manageable) credit risk.
– Get them oﬀ the balance sheet, by bundling them into MBSs, then CDOs.
– Sell the CDOs to the most bullish investors - presumably investors who think house
prices will not fall.
Eﬃciency versus moral hazard:
– The market seemed to do great job in making fund available, to pursue the Amer-
ican dream of home ownership.
– Securitization and credit derivatives were thought to make the ﬁnancial system
more robust, since investment risks are spread out, and and taken by parties most
willing and able to bear them.
– “Where once marginal applicants would simply have been denied credit, lenders are
now able to quite eﬃciently judge the risk posed by individual applicants, and price
that risk appropriately. These improvements have led to rapid growth in subprime
mortgage lending” - Alan Greenspan, as Fed Chairman.
– (See the FT article, Sept 19, 2008.)
• Moral hazard:
– In the last few years prudential standards in issuing mortgages have fallen: Alt-A,
NINJA, teaser-rate mortgages; ‘liar’ mortgage loans.
– These seem to have been fraudulent - the CDO buyers did not realise how risky
• The Asset substitution problem revisited:
– Since Fannie and Freddie had (implicit) Government guarantees, they could borrow
– Thus, it was proﬁtable to buy “private label” MBSs and related MBOs (see later),
which had higher yields.... proﬁtable!!!
– These instruments seemed to be reasonable investments, because they had AAA
3.2. Market breakdown:
• Property prices:
– Fuelled by cheap money (low interest rates), turbo-charged by “ﬁnancial innova-
– have collapsed.
– (They were a bubble!)
– Many of the AAA tranches of the CMOs have defaulted - theoretically impossible
(according to the models)!
– And this story applied not only to the property markets.
• Breakdown in the CDS market:
– These markets are opaque and inadequately regulated.
– Many CDSs were written (i.e. they took the short side) by AIG, an regulated as
“insurance” - but the principles of insurance do not apply, because the risk is not
– Many CDSs were written by hedge funds - who are not subject to any over-sight.
(Will this aﬀect the market?)
– Many CDSs were underwritten (i.e. arranged) by Lehman - what happened when
Lehman went bankrupt?
– See FT article, 10 January, 2009
• Breakdown in the CDO market:
– See “Wind down the 5 legged dogs”.
– FT March 10 article.
• Investment banks:
– Leverage ratio of 40 ×! - after the SPVs are taken back to the balance sheet.
– Balance sheets of the UK banks were bigger than the GDP of the UK!
– Too big, and systemically important, to fail - the banks have to continue to make
loans to keep the economy going.
– Many of the I Banks are now being kept aﬂoat by Government support (national-
3.3. Some history on the Investment Banks:
• Glass Steagall Act (1933):
– Passed in the wake of the 1929 Wall Street crash, and collapse of a large part of
the commercial banking system in early 1933.
– Separation of Commercial and Investment Banking.
– Commercial bank - can accept deposits, such as checking accounts, savings ac-
counts, and money market accounts, and can make loans. Deposits are guaranteed
by the Government (current limit US$ 250,000).
– Investment bank - limited to capital market activities.
– Motivation: Commercial banking is systemically important to the economy; invest-
ment banking is inherently risky.
• Gramm Leach Bliley Act 1999:
– Repealed the separation of commercial and investment banks, of the Glass-Steagall
– Motivation: “Economics 101 - The market is always right. Reduce regulation.”
– (From Wikipedia): “Individuals usually put more money into investments when
the economy is doing well, but they put most of their money into savings accounts
when the economy turns bad. With the new Act, they would be able to do both
’savings’ and ’investment’ at the same ﬁnancial institution, which would be able to
do well in both good and bad economic times.”
• The banks from 1999 to 2007:
– Going public - Many banks held IPOs, changing from partnerships to limited com-
– Exponential growth! - Revenue doubled between 2003 and 2007, to $ 84 billion!
– Proﬁts - by some accounts, the banks captured 50% of all earnings in the US!
– Innovation - CDSs CDOs, etc., which grew from a small base in 1999.
– “Misaligned incentives” (the asset substitution problem again!)
∗ The top oﬃcers expected to take home maybe $ 20 million per year in salaries
∗ If the bank fails, they won’t pay it back!
∗ If the bank is in distress, the Government will support it - so it can borrow
3.4. Some Theories of the Crisis:
1 Investment banks out of control:
– IBs have a risk taking culture.
– “Universal banks” (made possible y the repeal of the Glass-Steagall Act) - can
gamble with retail deposits, which are guaranteed by the Government.
– “Too big to fail” - everyone knows that the Government will step in if the bank
– This is again the Asset substitution problem. Wall street was betting that
house prices would continue to rise.
2 Mis-aligned incentives for bankers (bonuses):
– (Related to number  above.)
– Bankers are paid a bonus if their strategy wins in a particular year, and this cannot
be “clawed back”, if the strategy turns out later to have problems.
– (Easy strategy to make money in most years - write OTM index puts.)
– In fact the bankers does not have to care even if the bank goes bankrupt!
3 Erosion of diligence:
– Mortgage arrangers did not investigate whether the borrower could pay.
– Investors did not investigate the CDOs in detail - they accepted the judgements of
the rating agencies and the banks who created them.
– (Why ask questions, when you are making so much money?)
4 Defective oversight/regulation:
– The banks put the CDOs they created into SPVs, to get them “oﬀ the balance
sheet” This was sometimes referred to a “regulatory arbitrage”. It should have
been against the regulations!
– Many CDOs were “insured” by American International Group (IAG), which is an
insurance company. (In particular, AIG wrote CDSs on CDOs.) But AIG had
no basis on which it could make such insurance, and could not perform when the
insurance became due. The regulators seemed to miss this issue.
– Many people have pointed to the CDSs as triggering the Crisis - CDSs eﬀectively
enable short selling, but without any of the associated safeguards.
5 Defective models for CDO pricing:
– AIG, the rating agencies, and many investors, were relying on the Mathematical
CDO pricing models.
– But these now thought to be defective, since they were calibrated on a calm period
in ﬁnancial history.
– In fact, it is not thought than no model can accurately capture the value of a CDO.
6 Global imbalance of production and consumption:
– The Crisis is a crisis of leverage. So many have borrowed, and they now cannot
repay. But who wanted to lend in he ﬁrst place?
– The lenders were those with spare cash - the next exporting countries.
– Of these, China did not directly buy CDOs, etc, but Germany did.
3.5. Last words:
• ”Why is the United States, with the world’s largest economy, borrowing heavily on in-
ternational capital markets - rather than lending, as would seem more natural? ...
global saving glut ... boosted US equity values and helped to increase US home values,
as a consequence lowering US national saving and contributing to the nation’s rising
current-account deﬁcit”. - Ben Bernanke, March 2005.
• “When the music stops, in terms of liquidity, things will get complicated. But as long
as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Chuck
Prince, chairman of Citigroup, July 2007. (He resigned in October, 2007.)
• “Why did no one see this coming?” - Queen Elizabeth II of the United Kingdom, 2008.
• “What we thought was a wall of liquidity was really a all of leverage.” - anonymous
• “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when
he is ruined, is ruined in a conventional way along with his fellows, so that no one can
really blame him.” John Maynard Keynes, 1931.
Some supplementary readings:
A Brief History of the Secondary [US] Mortgage Market
(from R. Staﬀord Johnson, “Bond Evaluation, Selection and Management” (2004)):
In the early 1900, the lack of standardized mortgage contracts and regional diﬀerences in
real estate inhibited the development of an eﬃcient secondary market for existing mortgage
loans. Moreover, the lack of such a market translated into liquidity problems for lenders who
were unable to sell their mortgage notes. In 1938, the federal National Mortgage Adminis-
tration (FNMA - Fannie Mae) was formed, with the initial purpose of acquiring mortgage
notes. Combined with the Federal Housing Administration (FHA) and Veterans Adminis-
tration (VA) default insurance programmes, FNMA helped develop the present secondary
mortgage market. Speciﬁcally, the FHA’s programme of providing insurance for mortgage
lenders against defaults and the VA’s program of guaranteeing veterans’ mortgages had two
major eﬀects on the real estate lending market. Firstly, as intended, it reduced the default
risk characteristics of the mortgage, and secondly, FHA and VA, by providing such beneﬁts,
were able to insist on certain provisions governing the mar=turity, interest, down payments
and amortization schedule. This led to a more standardized mortgage contract across the
country. Moreover, the combination of uniformity and protection in mortgage notes - quali-
ties that enhanced marketability - facilitated the mortgage purchases made by FNMA and,
in turn, accelerated the development of the secondary mortgage market.
In 1968, FNMA was transformed from a federal agency, into a privately owned company.
FNMA was classiﬁed as a government-sponsored company. More precisely, FNMA was
deﬁned as a “private corporation with a public purpose”. As a result, FNMA’s charter then
stipulated that 5 of its 15 directors must be appointed by the President, that its debt limit
and debt-to-equity ratio be regulated, and that the Treasury hold a certain level of its debts.
These actions ensured some limited government control over this once public institution.
Operationally, FNMA raised funds through the sale of short-term and intermediate term
securities. From the proceed the acquired mortgages.
Since FNMA had historically tended to buy from mortgage companies, Congress created
the Federal Home Loan Mortgage Company (FHLMC - Freddie Mac) in 1970, to specialize
in the purchase of mortgages from S&Ls. Operating under the Federal Home Loan Bank
Board, the FHLMC served not only to help S&Ls, but also to extend the secondary market
from FHA and VA secured mortgages, to conventional mortgages (not federally insured).
The ﬁnal participant of note in the secondary market was the Government National Mort-
gage Association (GNMA - Ginnie Mae). Created after FNMA was converted to a private
company, GNMA, under its liquidity management programme, initially bought mortgages
from S&Ls and mortgage bankers, and then sold them under a tandem programme to FNMA
and FHLMC, or packaged the mortgages and sold them to large institutional investors.
“End of Illusions” - Extract from the Economist, July
THERE is a story about a science professor giving a public lecture on the solar system.
An elderly lady interrupts to claim that, contrary to his assertions about gravity, the world
travels through the universe on the back of a giant turtle. ”But what supports the turtle?”
retorts the professor. ”You can’t trick me,” says the woman. ”It’s turtles all the way down.”
The American ﬁnancial system has started to look as logical as ”turtles all the way down”
this week. Only six months ago, politicians were counting on Fannie Mae and Freddie Mac,
the country’s mortgage giants, to bolster the housing market by buying more mortgages.
Now the rescuers themselves have needed rescuing.
After a headlong plunge in the two ﬁrms’ share prices, Hank Paulson, the treasury secre-
tary, felt obliged to make an emergency announcement on July 13th. He will seek Congress’s
approval for extending the Treasury’s credit lines to the pair and even buying their shares
if necessary. Separately, the Federal Reserve said Fannie and Freddie could get ﬁnancing at
its discount window, a privilege previously available only to banks.
The absurdity of this situation was highlighted by the way the discount window works.
The Fed does not just accept any old assets as collateral; it wants assets that are ”safe”.
As well as Treasury bonds, it is willing to accept paper issued by ”government-sponsored
enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac.
In theory, therefore, the two companies could issue their own debt and exchange it for loans
from the governmentthe equivalent of having access to the printing press.
Absurd or not, the rescue package notched up one immediate success. Freddie Mac was
able to raise $3 billion in short-term ﬁnance on July 14th. But the deal did little to help the
share price of either company or indeed of banks, where sentiment was dented by the collapse
of IndyMac, a mortgage lender. The next day Moody’s, a rating agency, downgraded both the
ﬁnancial strength and the preferred stock of Fannie and Freddie, making a capital-raising
exercise look even more diﬃcult. As a sign of its concern, the Securities and Exchange
Commission, America’s leading ﬁnancial regulator, weighed in with rules restricting the
short-selling of shares in Fannie and Freddie.
The whole aﬀair has raised questions about the giant twins. They were set up to provide
liquidity for the housing market by buying mortgages from the banks. They repackaged
these loans and used them as collateral for bonds called mortgage-backed securities; they
guaranteed buyers of those securities against default.
This model was based on the ability of investors to see through one illusion and
boosted by their willingness to believe in another. The illusion that investors saw
through was the oﬃcial line that debt issued by Fannie and Freddie was not backed by the
government. No one believed this. Investors felt that the government would not let Fannie
and Freddie fail; they have just been proved right.
The belief in the implicit government guarantee allowed the pair to borrow cheaply. This
made their model work. They could earn more on the mortgages they bought than they
paid to raise money in the markets. Had Fannie and Freddie been hedge funds, this strategy
would have been known as a ”carry trade”.
It also allowed Fannie and Freddie to operate with tiny amounts of capital. The two
groups had core capital (as deﬁned by their regulator) of $83.2 billion at the end of 2007;
this supported around $5.2 trillion of debt and guarantees, a gearing ratio of 65 to one.
According to CreditSights, a research group, Fannie and Freddie were counterparties in $2.3
trillion-worth of derivative transactions, related to their hedging activities.
There is no way a private bank would be allowed to have such a highly geared balance
sheet, nor would it qualify for the highest AAA credit rating. In a speech to Congress in
2004, Alan Greenspan, then the chairman of the Fed, said: ”Without the expectation of
government support in a crisis, such leverage would not be possible without a signiﬁcantly
higher cost of debt.” The likelihood of ”extraordinary support” from the government is cited
by Standard Poor’s (SP), a rating agency, in explaining its rating of the ﬁrms’ debt.
The illusion investors fell for was the idea that American house prices would not fall across
the country. This bolstered the twins’ creditworthiness. Although the two organisations have
suﬀered from regional busts in the past, house prices have not fallen nationally on an annual
basis since Fannie was founded in 1938.
Investors have got quite a bit of protection against a housing bust because of the type
of deals that Fannie and Freddie guaranteed. The duo focused on mortgages to borrowers
with good credit scores and the wherewithal to put down a deposit. This was not subprime
lending. Howard Shapiro, an analyst at Fox-Pitt, an investment bank, says the pair’s average
loan-to-value ratio at the end of 2007 was 68%; in other words, they could survive a 30%
fall in house prices. So far, declared losses on their core portfolios have indeed been small
by the standards of many others; in 2008, they are likely to be between 0.1% and 0.2% of
assets, according to SP.
Of course, this strategy only raises another question. Why does America need government-
sponsored bodies to back the type of mortgages that were most likely to be repaid? It looks
as if their core business is a solution to a non-existent problem.
However, Fannie and Freddie did not stick to their knitting. In the late 1990s they
moved heavily into another area: buying mortgage-backed securities issued by others. Again,
this was a version of the carry trade: they used their cheap ﬁnancing to buy higher-yielding
assets. In 1998 Freddie owned $25 billion of other securities, according to a report by its
regulator, the Oﬃce of Federal Housing Enterprise Oversight (OFHEO); by the end of 2007
it had $267 billion. Fannie’s outside portfolio grew from $18.5 billion in 1997 to $127.8 billion
at the end of 2007. Although they tended to buy AAA-rated paper, that designation is not
as reliable as it used to be, as the credit crunch has shown.
Sometimes the mortgage companies were buying each other?s debt: turtles propping each
other up. Although this boosted short-term proﬁts, it did not seem to be part of the duo?s
original mission. As Mr Greenspan remarked, these purchases ”do not appear needed to
supply mortgage market liquidity or to enhance capital markets in the United States”.
Joshua Rosner, an analyst at Graham Fisher, a research ﬁrm, who was one of the ﬁrst
to identify the problems in the mortgage market in early 2007, reckons Fannie and Freddie
were buying 50% of all ”private-label” mortgage-backed securities in some yearsthat is, those
issued by conventional mortgage lenders. This left them exposed to the very subprime assets
they were meant to avoid. Although that exposure was small compared with their portfolios,
it could have a big impact because they have so little equity as a cushion.
In the end, the turtle at the bottom of the pile is the American taxpayer. But that
suggests that, if Americans are losing money on their houses, pensions or bank accounts,
the right answer is to tax them to pay for it. Perhaps it is no surprise that traders in the
credit-default swaps market have recently made bets on the unthinkable: that America may
default on its debt.
Note in postscript:
Fannie and Freddie have been nationalized, since this article was written.