Abstract
This 2008 Article IV Consultation highlights that problems in the housing and financial markets over the past year have combined to slow the United States’ economy substantially. As the residential investment downturn accelerated and national indices of housing prices started falling, mortgage defaults rose sharply, and bank losses mounted. Policymakers have responded aggressively to these developments. IMF staff analysis suggests that the dollar is closer to its medium-term equilibrium level, although still on the strong side.
Recent problems at Fannie Mae and Freddie Mac illustrate that the dynamic interactions between the financial sector and housing cycles highlighted in the staff report, and the knock on effects on overall activity, have yet to fully play out. As such, the thrust of the staff appraisal remains unchanged.
1. Recent severe market pressures forced a rescue of Fannie Mae and Freddie Mac, including access to Fed loans and a request to Congress for direct government support. The dramatic loss in confidence in the two main housing government-sponsored enterprises (GSEs) was triggered by reports suggesting that accounting rule changes could take around $75 billion off Fannie and Freddie’s capital. Whatever the merits of the analysis, the market response reflects underlying concerns over the GSEs’ capital cushions in the face of falling house prices—not subprime mortgages—and political pressure to increase their exposure to the housing bust. These come on top of long-standing concerns about an inadequate regulatory regime. On July 13 the Treasury proposed to eliminate the existing $4½ billion cap on its lending authority to the GSEs and to gain permission to buy equity. In the interim, the Fed’s balance sheet is now available through collateralized borrowing to provide a liquidity backstop to calm market fears.
2. As with Bear Stearns, the final outcome of the weekend rescue is likely to be that equity holders lose money but debt holders will be protected. The GSEs’ equity prices fell by 80 percent in the week before the announcement and—with naked short selling of their securities suspended—remain around this level. Auctions of GSE bonds, however, are proceeding smoothly and their spread over Treasuries is stable. With markets concluding that the implicit government guarantee of debt is real, the GSEs should continue to function fairly normally.
Financial Sector Equity Prices
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.Financial Sector Equity Prices
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.Financial Sector Equity Prices
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.3. With banks also being pressured by housing woes, the deterioration in overall financial conditions is broadly consistent with the staff’s financial forecast. Reflecting these pressures, a retail deposit run on IndyMac bank, a large Californian mortgage specialist, led to its intervention by federal regulators—the third biggest depository failure in U.S. history. The CDS spreads of large commercial and investment banks have also widened significantly, with those of Lehman Brothers and Wachovia close to or above levels at the time of the Bear Stearns crisis. More generally, interbank spreads remain elevated, the yield curve has steepened, and the high-yield spread has widened close to the levels typical of a recession.
Investment Bank Credit Default Swap Spreads
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.Investment Bank Credit Default Swap Spreads
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.Investment Bank Credit Default Swap Spreads
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.4. Given the two GSEs’ systemic and global importance (Box 1), staff support the rescue, but existing shareholders should take major losses. The authorities have stressed that they aim to keep these institutions as shareholder-owned entities. One way forward would be government assumption of temporary control through issuance of preferred equity that dilutes current shareholders. Passing the improved regulatory regime—including receivership—already in the proposed housing bill should also be a priority, as discussed in the staff report. Consideration of this bill has been delayed to allow inclusion of requested provisions for the government to provide direct support to the GSEs.
Commercial Bank Credit Default Swap Spreads
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.Commercial Bank Credit Default Swap Spreads
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.Commercial Bank Credit Default Swap Spreads
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Source: Bloomberg, L.P.5. The long-term role of Fannie and Freddie will need to be rethought, with staff contributing via next year’s Financial Sector Assessment Program. The tension has always been that cheap funding from the assumed government guarantee allowed the GSEs to benefit their shareholders by expanding their portfolios while exposing taxpayers to risk. One approach would be to break them into entities small enough to be allowed to fail, removing their special charters and the presumption of government backing. Alternatively, Chairman Bernanke has suggested that they could be kept in their current form—presumably with strict prudential oversight and portfolio limits to constrain their benefit from cheap funding. In any case, as discussed in the staff report, they should be regulated like private institutions to ensure supervisory consistency.
Fannie Mae and Freddie Mac: A Primer
These GSEs have long been seen as “too big to fail”—they hold or guarantee about half of U.S. residential mortgages, their securities widely serve as collateral, and their derivatives activity is extensive (see Figure).
Congress created these GSEs to support reliable and affordable mortgage financing, limiting their guarantees to conforming mortgages (with ceilings on size and risk). With their private ownership and public mission involving Congressional oversight, markets have long assumed that they enjoy an implicit government guarantee, although the U.S. authorities have consistently denied this. The belief stems from their size and unique charters that include credit lines from the Treasury, privileged bank regulatory treatment of their bonds, and a weak supervisor with only conservatorship (going concern) not receivership (closure) authority.
Fannie and Freddie, which are highly leveraged, bear the largest exposures to U.S. housing-related credit risk. Their combined balance-sheet size was about $1½ trillion at end-2007 and the GSEs have guaranteed a further $4¼ trillion. Almost one-fifth of total agency issued debt and guaranteed securities are held abroad. Reflecting the traditional risk-insensitivity of their funding costs and relatively loose regulatory requirements, their equity capital to total assets has generally stood at 3–4 percent, similar to that at the large U.S. investment banks, but about half of comparable ratios at U.S. commercial banks.
GSE statistics, end-2007
GSE statistics, end-2007
| USD trillion | Percent of U.S. GDP | Percentage of U.S. mortgages | |
|---|---|---|---|
| Housing market | |||
| Owned | 1.4 | 10.4 | 12.9 |
| Guaranteed | 4.2 | 30.1 | 37.3 |
| Financial markets | |||
| Debt outstanding | 1.5 | 11.1 | 13.8 |
| MBS guaranteed | 4.2 | 30.1 | 37.3 |
| Total held abroad | 1.5 | 10.8 | 13.4 |
| Core capital | 0.08 | 0.6 | 0.7 |
GSE statistics, end-2007
| USD trillion | Percent of U.S. GDP | Percentage of U.S. mortgages | |
|---|---|---|---|
| Housing market | |||
| Owned | 1.4 | 10.4 | 12.9 |
| Guaranteed | 4.2 | 30.1 | 37.3 |
| Financial markets | |||
| Debt outstanding | 1.5 | 11.1 | 13.8 |
| MBS guaranteed | 4.2 | 30.1 | 37.3 |
| Total held abroad | 1.5 | 10.8 | 13.4 |
| Core capital | 0.08 | 0.6 | 0.7 |
In addition to credit risk, the two enterprises also have large exposures to market risk and play a systemic role in derivatives markets. The mortgage guarantees pose credit and reputational risk, while the investment portfolios run the gamut of credit, interest rate, prepayment, and pricing risk. They are also key players in the OTC interest rate derivatives markets as they seek to hedge interest rate and prepayment risks using swaps and options on swaps (swaptions).
Reflecting their privileged position, the two GSEs were able until recently to raise equity capital cheaply and to produce high returns for their shareholders. The implicit guarantee kept the borrowing cost just above that on Treasury securities, even as the low capital requirement allowed the GSEs to boost their portfolios. Large exposure to mortgages and a thin capital cushion is at the root of market concerns about GSE solvency as the housing crisis has led to a rise in defaults, including on prime mortgages.
The Housing GSEs in Perspective
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Sources: Board of Governors of the Federal Reserve; Office of Federal Housing Enterprise Oversight; Haver Analytics; and Fund staff estimates.The Housing GSEs in Perspective
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Sources: Board of Governors of the Federal Reserve; Office of Federal Housing Enterprise Oversight; Haver Analytics; and Fund staff estimates.The Housing GSEs in Perspective
Citation: IMF Staff Country Reports 2008, 255; 10.5089/9781451839715.002.A003
Sources: Board of Governors of the Federal Reserve; Office of Federal Housing Enterprise Oversight; Haver Analytics; and Fund staff estimates.6. Systemic risks from the GSEs have long been a well understood problem and key policy issue, but political consensus in Congress has been elusive. The Treasury, Fed, and Fund have repeatedly emphasized the topic over many years (Box 2).
Staff’s Analysis of Fannie Mae and Freddie Mac
Staff reports since 2003 have consistently stressed that, in view of Fannie Mae and Freddie Mac’s systemic importance, there is a need to monitor closely their risk management and accounting practices and reform their regulation. More specifically:
Size of portfolios. Staff have supported proposals by the Treasury and the Fed to cap these enterprises’ portfolios, to restore their focus on securitization of conforming mortgages, and to limit their special status, to discourage the market perception of an implicit government guarantee of their liabilities.
Interest and mortgage prepayment risk. Staff have also repeatedly observed that the growth of these institutions has concentrated interest rate and mortgage prepayment risk, with the attendant hedging operations also leading to concentration in some derivative markets.
Overhauling the supervisory arrangement. The staff have strongly backed Treasury proposals to create a new regulator with full powers to set risk-based capital requirements, to design stress tests, and to place a housing GSE into receivership in the event of a financial insolvency.
