Safety & Soundness: Do the Housing GSEs Threaten the US Economy? August 29, 2005
Los Angeles - On August 16, Dawn Kopecki of Dow Jones News Service
filed a story, "Atlanta Fed Paper Says GSE's Fuel US Housing Market," which
seemingly began a cascade of requests for the favorite page on the IRA web site.
That page shows the percentage of obligations issued by government
sponsored enterprises held as assets on the balance sheets of American
Released on August 5, 2005
by Federal Reserve Bank of Atlanta staff economist Karsten Jeske and German
economist Dirk Krueger, the Working Paper "says the nation's three housing
government-sponsored enterprises have helped fuel the red hot housing sector
with policies that primarily benefit wealthier consumers, drive up U.S. housing
stock, increase rental prices and lead to higher default rates,"
So offensive was the paper to the mortgage
lobby that economists at Freddie Mac (NYSE:FRE) and the Mortgage Bankers
Association went on record refuting the paper as soon as it was released. Jay Brinkman, VP of
Research and Economics at the MBA, was quoted saying the "results are hard to believe." Ms. Kopecki
recorded Freddie Mac Senior Economist Frank Nothaft asserting that "With each assumption, it takes away
from the reality of how the market works."
What was the Atlanta Fed paper saying that warranted that kind of public rebuke by the
mortgage industry? Economists are notorious for slinging hash at each other's equations, but
this initial clash suggests something more serious. For background, look at a the working paper
by Jeske and Krueger and earlier papers published in May 2005 by Rosalind Bennett (FDIC), Mark Vaughn (FRB-Richmond) and Timothy Yeager (FRB-St. Louis) and in 2002 by Scott Frame and Larry Wall both from the Atlanta Fed.
Readers of Washington & Wall Street will recall that
Fed Chairman Alan Greenspan, in his testimony last month before the Senate
Banking Committee, explained that prudential concepts such as safety and
soundness cannot be applied to the swelling balance sheets of the GSEs
because they do not have sufficient capital to "self insure" like commercial
banks. Click here to see the top 100 bank units over $1B in total
assets that invest heavily in GSE debt. Note that the $30 billion asset, UT-based thrift subsidiary of
Washington Mutual (NYSE:WM) has over 65% of its tangible assets in GSE debt --
and this is not the most extreme example.
The core thrust of Jeske and Krueger has to
do with measuring the interaction of safety and soundness concerns between the
worlds of the GSEs and the banks that use FHLB Advances to fund their
operations. Of note, most of the FHLBs have been forced to delay their
filings with the SEC because of problems with internal controls and accounting
The Atlanta Working Paper is ground breaking because it asks whether
or not the "perverse consequences" discussed in research papers written one business
cycle ago by Frame and Wall have in fact manifested, an issue which Chairman Greenspan and
Treasury Secretary John Snow publicly raised in congressional appearances with respect to the GSEs.
The Richmond working paper by Bennett, Vaughn and Yeager sets up a computation structure that
attempts to measure the net magnitude of the problem using a bottoms up approach. Working paper models normally ooze with
evidence that the many coefficients are only beginning to be calibrated. One would think that other economists would
take an academic interest in helping to calibrate the "swags," but given that these works asks a rather uncomfortable
question we can see some people would rather not.
If cheap money FHLB Advances
are used irresponsibly to superheat bank profitability, for example by
creating a subsidized class of sub-prime loan product, does
this generate a downside "moral hazard" risk that the FDIC may have to make
good on the FHLB Advances? That question certainly does seem
worthy of a "safety and soundness" analysis by both OFHEO on the GSE side and
the bank regulators at the Fed, OCC, OTS, FFIEC and FDIC.
Ironically, the statute empowering OFHEO refers to "safety and
soundness" as one of the criteria for measuring the financial state of GSEs such
as the FHLBs, FRE and Fannie Mae (NYSE:FNM), ridiculous as that may be in
purely financial terms. As Chairman Greenspan explained in his exchange with
Senate Banking Committee Chairman Richard Shelby (R-AL) on July 21,
2005, prudential tests such as safety and soundness cannot be applied to
the GSEs -- whether the housing statute says so or not -- because they simply
have too little capital to withstand losses on their greatly expanded mortgage
The whopper assumption in the Richmond exercise is that a bank relying upon FHLB Advances
excess of 15% of total assets is cause for concern. Indeed, they suggest that
such a business posture could activate a CAMELS rating downgrade which
places the subject institution into a category disqualifying it from accessing
any FHLB Advances. Bank regulators, after all, are not
interested in maximizing housing originations; their job is to make sure nobody bites
a chunk out of the Bank Insurance Fund (BIF).
Jeske and Krueger attempt to examine the consequence of the so-called "implicit guarantee" and quantify
the effects that may have resulted. The combined body of research posits an intriguing shock
where bank regulators take out the Prompt Corrective Action (PCA) chain saw and direct that all banks
liquidate FHLB Advances back down below the 15% safe and sound mark. Reducing FHLB Advances by all US banks below 15% of assets would force the market to absorb
tens of billions of dollars worth of GSE paper -- paper that the Sell Side dealer community could not
easily place elsewhere.
Economists at the GSEs and MBA are of course correct in observing that a draconian reduction in FHLB
Advances is unlikely barring an "extraordinary event" -- like large blocks of sub-prime mortgages going into
non-accrual and new originations going flat as a pancake because $3.00 a gallon gasoline has broken the
back of consumer disposable income. No, that would never happen.
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