In a recent speech to the UBS Financial Services Conference, Fannie Mae CEO Franklin Raines described the role of the GSEs in a way that sounds very analagous to what central banks do. (This quote was reported by The GSE Report).
In a speech to the UBS Finance Services Conference, Fannie Mae chairman and CEO Franklin Raines predicted that commercial banks will soon lose their appetite for investing in mortgages as interest rates rise. Raines said, “In the carry trade, the bank, hedge fund, real estate investment trust, or other-fixed income investor buys long-term, fixed-rate mortgages and funds them with short-term liabilities, and hedges very little if at all. When short-term rates are low and the yield curve is steep, the carry trade can make a very good spread and return. Banks, for example, can earn 300-400 basis points on these mortgages.”
Short term interest rates are low now because the Fed sets these rates and is now pegging them very low. As Raines explains, this allows banks to recycle mortgage debt through Fannie. The banks originate the mortgages, sell them to Fannie which securitizes them and resells them. The securitization process transfers the default risk but not interest rate risk to Fannie. Fannie claims to hedge interest rate risks by purchasing interest rate derivatives. Recent changes in their balance sheet have called into question how good a job they are doing at this, but even if they were, it only transfers trillions of dollars of exposure to some other play in the fianancial system.
This whole process is extremely unproductive economically because it channels savings and credit into consumption rather than investment. Why should banks make risky loans to businesses when they can earn, as Raines says, 300-400 basis points with essentially on risk...other than being borrowed short and lent long. The big question now is what will happen when interest rates rise. Raines continues:
“The one thing we know is that the carry trade that banks conduct in mortgages can’t last forever.” Raines argued that Fannie Mae plays a critical role in providing liquidity to the market when other investors no longer find it profitable to invest in mortgages. “Without our mortgage portfolio, both investors and consumers would feel the pain,” Raines said. Investors would not be able to find a ready buyer when they want to sell mortgage holdings and mortgage rates would “skyrocket” - hurting consumers, he claimed. “But we will be ready to stabilize the mortgage market,” said Raines. “This will give Fannie Mae an opportunity to grow its portfolio,” he added.
So what Raines seems to be saying is that Fannie will function as a buyer of last resort of mortgage-backed securities. Without Fannie, these securities could perhaps be sold to someone, but at a much lower price. What Raines seems to be describing is putting a floor under the price of MBS. Fannie has come under criticism for its portfolio of MBS.
Critics have charged that the GSE should only try to create a secondary market for MBS, not to become one of the largest buyers as well. One might ask, if it is no longer profitable for investors to invest in mortgages isn’t that a market signal that scarce capital is more urgently needed elsewhere in the economy? And that continuing to pour resources into housing at that point is at the cost of some greater consumer satisfaction presently or down the road?
