By R. Christopher Whelan
This article originally appeared in The Institutional Risk Analyst.
“Because uncertainty about the future is fundamental, financial mistakes will continue to be made. They will be made by entrepreneurs, bankers, borrowers, central bankers, government regulators, politicians, and, notably, by the interaction of all of the above.”Alex Pollock, Boom & Bust: Financial Cycles and Human Prosperity
New York – In this article, we consider the practical aspects of systemic risk, something that everyone talks about but nobody seems able to understand or quantify. And we are reminded of the wisdom of our friend Alex Pollock, formerly of R Street Institute and now Principal Deputy Director at the Office of Financial Research. He wrote in his 2010 book which we quote above:
“How can you regulate the systemic risk when you are the systemic risk?”
Witness the world of nonbank finance. A few months back, we were warned by no less authority than the Financial Stability Oversight Council or “FSOC” that nonbank financial companies were a source of systemic risk. Mark Calabria, who heads that world class regulatory agency known as the Federal Housing Finance Authority or FHFA, apparently encouraged this line of thinking. And Director Calabria and the FSOC turn out to be totally wrong.
Instead of nonbanks causing systemic risk, in fact the mounting threat to the US financial system is coming from government sponsored enterprises and the members of the FSOC itself, particularly Mr. Calabria. The FHFA is led by somebody who thinks his job is to “protect the taxpayer” – even if this means standing by as the conventional mortgage market implodes due to a lack of liquidity — liquidity for obligations that are guaranteed by the United States.
Last week, the GSEs Fannie Mae and Freddie Mac had a liquidity facility ready to put in place to support issuers. Meetings were scheduled with members of Congress to discuss the plan. Then suddenly, Mr. Calabria told the GSEs to stand down and shelve plans to support the industry. To say that people in and around the housing industry were flabbergasted is an understatement.
Following Calabria’s action to shut down the servicer liquidity facility planned by the GSEs, the FSOC met and decided to take a “wait and see” approach to providing liquidity to mortgage servicers, banks and nonbanks alike. Again, we are told that the FSOC’s decision was largely taken because of erroneous advice from Director Calabria, who has never actually worked in finance much less in the housing industry.
As we note in our comment in National Mortgage News, “Financial tsunami threatens housing sector,” the mortgage industry can probably manage to make the April payments of principal and interest due on $11.5 trillion in agency and government insured mortgage backed securities. But by May, the national payments system will be running out of money and the Treasury will face default. The alarm bells are already ringing in Washington and at central banks around the globe.
If a government issuer has a deficiency as a result of the Congressionally mandated payment holiday, then they will notify Ginnie Mae and the agency will then call the Treasury to seek financial support to pay the bond holders. If a conventional issuer has a deficiency as a result of the Congressionally mandated payment holiday, then they will notify Fannie Mae and Freddie Mac, which will immediately inform the FHFA. The FHFA, in turn, will call the Treasury seeking financial support. All roads lead back to the Treasury and Secretary Steven Mnuchin.
After counseling the FSOC the take a “wait and see” attitude on providing liquidity to nonbanks, including the GSEs it’s important to add, Director Calabria then decided to give an interview to the Financial Times. In the interview, Calabria predicted that the GSEs will run out of money in just six weeks and will then require yet another federal bailout. Mr. Calabria loves talking to the media, you see.
Calabria’s ill-considered comments made many people in the mortgage industry question the judgment and state of mind of the FHFA head. For one thing, federal regulators are not supposed to make gratuitous comments in the media about the financial institutions they regulate. His actions seem calculated to undermine confidence in the GSEs and the mortgage market.
As one leading mortgage industry CEO told us on Friday: “No action IS an action. Calabria is turning into the caricature people feared if/when a crisis hit.”
The failure of the FHFA to allow the GSEs to provide liquidity support to servicers of conventional loans is not only threatening the solvency of mortgage firms and smaller banks, but it is also negatively impacting the new issue market for MBS.
Years from now, Director Calabria may be remembered for starting the housing industry meltdown of 2020. What investor would want to buy Fannie Mae or Freddie Mac securities if they are uncertain as to whether the inevitable arrears from payment holidays can be financed? The same goes for Ginnie Mae MBS, government guarantee or not.
Of course, Director Calabria claims to be concerned about “protecting the taxpayer,” but his actions say quite the opposite. It’s almost as though Calabria was intentionally trying to make things worse in the mortgage finance sector. The collapse of the agency mortgage market is a far greater danger than any short-term losses the GSEs may absorb. Again, Mark, agency securities are guaranteed by the United States.
And the irrational and dangerous actions of Director Calabria are also visible with the other GSEs. Witness the experience of prime mortgage issuer Redwood Trust (NYSE:RWT), which was apparently pushed away last week from the Federal Home Loan Banks and forced to sell a large chunk of agency mortgages at a double-digit loss. JMP Securities wrote last week:
“[I]t appears FHLB Chicago made changes to the terms of its lending relationship with Redwood that caused the company to elect to voluntarily and quickly step away from that facility. While there are certainly other significant challenges facing mortgage lenders and investors these days, we believe the souring of this relationship was a major contributor to updated results disclosed on April 2.”
With the GSEs backing away from the very markets they are meant to support, is there any question that the FHFA is following the wrong policies? Without immediate action to provide liquidity to servicers of both conventional and government loans, the US mortgage market is going to seize up. When the servicers cannot fund their operations, then the new issue market will come to a halt – as it has now.
Because of the ill-considered actions of the FHFA, the US Treasury may now be forced to take the GSEs out of conservatorship and take formal control of both Fannie Mae and Freddie Mac by converting the government’s warrant into common equity. By taking active control of the GSEs, the Treasury can push aside Director Calabria and the FHFA, and get the GSEs to work providing liquidity to the conventional market.
The current mess in the housing sector is entirely the fault of Washington, a city which is so dysfunctional and so conflicted that it cannot even allow the agencies created to support financial markets in time of stress to operate correctly. Anybody who thinks that the market for US Treasury securities can survive the collapse of the agency and government-insured mortgage markets should think again.
President Donald Trump needs to remove Director Calabria from his position at the FHFA forthwith and direct the Treasury to take control of the GSEs. We must get Fannie May and Freddie Mac into the fight to save the conventional mortgage market – and the US financial system – from a serious and unnecessary crisis. And we must act quickly because the opening of trading in the US bond market is likely to be messy on Monday.
R. Christopher Whalen is an investment banker and author who lives in New York City.