Five years after the 2008 financial panic, there are still no concrete plans for what to do with the twin mortgage finance giants, Fannie Mae and Freddie Mac. The only consensus among Congress, the Obama administration, regulators and the banking industry is that no one knows what to do. No clear compelling vision for the federal government's role in residential mortgage finance has yet to be offered by a party to the debate.
An essential requirement is any reform must deal decisively with the moral hazard baked into the current system. As recent events have painfully demonstrated, mortgage originators have every incentive to pump up the volume, casting a wide net, by cutting underwriting standards. Bad behavior is encouraged whether the mortgages are bought and repackaged by the government sponsored entities (GSEs) or by private asset-backed issuers. Now, if years later a bank is caught peddling duff mortgages, the resulting fine is just a belated cost of doing business.
But complete privatization -- with no implicit or explicit federal guarantee -- may not be a viable option. Certainly, a privately owned entity has every incentive to push back dud loans to originators. Even a sterling quality mortgage portfolio though must be financed and supported by equity capital. In banking, alas, equity capital does not come cheap.
Historically, a 15% per annum return on equity (ROE) has been a yardstick adopted by banks. Since banking as a business has low returns on assets (ROA), with a median in 2012 of 80 basis points (bp), the only way to reach a ROE hurdle of 15% is to leverage up. New bank capital guidelines -- both the Basel III rules and the Dodd-Frank legislation — place stricter limits on the risk a bank can take through leverage. Under the new framework, performing, secured first lien mortgages are assigned a 50% risk weighting. For a bank, exclusively engaged in financing residential mortgages, to be deemed well capitalized (above 10%) requires it to hold a $5 buffer for every $100 of mortgage loans.
All other factors held constant, this restriction implies the bank must earn at least 75 basis points (bps) on its assets to meet its ROE objective. In a perfect world, with no non-performing assets, the goal may be attainable. But, once one tightens the assumptions, the needed ROA threshold jumps.
This is the problem with utilities: they still must be financed. A privatized version of either Fannie Mae or Freddie Mac would be just that. To be viable, such utilities must earn a competitive return; otherwise, long-term, investors have no incentive to put their capital at risk.
Unless an entity enjoys a borrowing advantage, lowering its funding costs, focusing on high quality mortgages is unlikely to generate attractive returns. Conversely, the entity could limit itself to riskier mortgages. But buyers may demand some form of credit enhancement -- a feature that effectively reduces the issuer's margins. So, an entity enjoying a quasi government guarantee thus has the best of both worlds. Because investors view it as an arm of the government, it is able to borrow at preferential rates. Likewise, in the event mortgages fail en masse, bond holders can petition the government for redress. Sounds like the exact set-up that got us into the present mess.
Since any reform requires an act of Congress, we do not foresee a resolution in 2014. Until then, the Federal Reserve is unlikely to sharply curtail its role in the mortgage finance market. Given the uncertainty, few will be enticed back into the market, since investors have no reason, long-term, to count on an iron-clad government guarantee. The Treasury has every incentive to make any guarantee as tenuous as the markets will tolerate. Otherwise, it may be compelled to treat Fannie's and Freddie's debt as full-faith and credit issues, thus raising in one swoop the nation's indebtedness. For the moment, Chairwoman Yellen can only persevere in the Fed's repair of the nation's home finances.
Notes on Sources, Methods and Definitions:
Data was compiled from the Federal Reserve Board's quarterly Z1 report, Financial Accounts of the United States for the years spanning 2008 to 2012 and the first three quarters in 2013. Data pertaining to the origination, financing and securitization of residential home mortgages was gleaned from a number of different tables. Totals are not inclusive and exclude sectors and participants playing a smaller role in the nation's mortgage financing markets. The intent is to capture the dominant flows of major participants since the 2008 financial crisis. Red lines indicate outflows from a sector; green lines indicate inflows to a sector.
Government sponsored enterprises (GSEs) include Fannie Mae, Freddie Mac, Ginne Mae and the TVA among others. Private ABS (asset-backed securities) issuers reflect flows in special purpose vehicles created expressly to facilitate the securitization of mortgages, car loans and credit card receivables. Such vehicles are often created to enable financial intermediaries to shed assets from their balance sheets.
Return on assets (ROA) is a commonly used measure of the management's efficiency in using a firm's assets. It is typically computed by dividing after tax net income during the year by average assets. Return on equity (ROE) is another such efficiency measure to assess management's success in employing the firm's equity capital. It is computed typically by dividing net income (after taxes) for the year by the average equity capital on the firm's balance sheet.
(Sources: Federal Reserve Board; AIFS estimates.)
About American Independence Financial Services, LLC
American Independence Financial Services, LLC ("American Independence") is the investment adviser and administrator for the American Independence Funds. The firm is a limited liability company founded in 2004. It is majority owned by its senior management, who average over 25 plus years of industry experience and achievement. Today, American Independence offers eleven different mutual funds and manages approximately $1 Billion in assets on behalf of its clients.
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Important Disclosures
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The views expressed in this document are based on political, market, economic and other conditions subject to change at any time. Data are acquired from sources believed to be reliable. But no warranties are made to the accuracy, completeness or timeliness of the data and information presented. Opinions expressed are those of the author unless indicated to the contrary. Nothing in this document should be construed or taken as financial or investment advice. Please consult with your financial advisor to discuss how the subject of this research report may impact your unique, individual circumstances.
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