8 ms·

An insider's explanation of the Fannie Mae Meltdown

71 points by bokonist 18y ago

ctkrohn 18y ago
To the finance & trading nerds out there: here's why callable debt is such a big deal. Like everything else in the mortgage bond world, it all comes down to prepayments. Borrowers have the option to prepay their mortgage by refinancing or simply by paying more than the minimum requirement. Because of the prepayment option, mortgages have a duration (defined as the average maturity of the cash flows, weighted by the present value of the cash flows) much less than their 30-year term. For example, the 10yr treasury note has a duration of just over 8 years, but FNCL 5.5 TBA mortgage futures (the most liquid type of mortgage-backed security) have a market-implied duration of around 5 years. Duration also measures the sensitivity of a bond's price to interest rates: for longer duration bonds, you are discounting the cash flows further back in time, so the rate at which you value future cash will have a greater effect on the present value. Think about it: if you are to receive $1000 in six months, it won't much matter to you if interest rates are at 1% or 10%. If the financial situation is relatively normal, $1000 in six months isn't worth much less than $1000 now. But a 30-year bond yielding only 1% is almost worthless (why would you lock up your money for 30 years at such a low rate), while one yielding 10% is extremely valuable. If prepayment speeds were static (i.e. if people always paid off their mortgages at the same rate), Fannie Mae could issue debt with 5-year duration (probably ~7yr maturity) at, say, 5%, and buy 30-year mortgages (also with 5-year duration) yielding 6%. They would thus make 1% per year, and on average they would pay off their own debt right when the borrower pays off his mortgage. Fannie and Freddie do issue debt in this form, referred to as bullets. The problem is that agency bullets have a very different convexity profile than mortgages. (If duration is the sensitivity of prices to interest rates, convexity is the sensitivity of duration to interest rates). Bullets have positive convexity: as interest rates go down, the bond has a longer duration. With low interest rates, future money isn't worth much less than money now. So when you are computing duration, the large cash flows towards the end of the bullet's life are dominant. Mortgages are exactly the opposite: they have negative convexity. As interest rates go down, a mortgage's duration gets shorter because borrowers refinance out of their old mortgage into a new one at a lower rate. If rates go up, the opposite happens. So suppose rates go up. The debt that Fannie issued trades to a shorter duration, but the mortgages they own trade longer. This means that on average, Fannie would have to pay off its debt faster than the borrowers pay off their mortgages. When Fannie's debt comes due before the mortgages, Fannie will have to refinance. And since rates went up in this scenario, it will have to refinance into more expensive debt than before. Now imagine rates go down. Fannie Mae's debt trades longer, and mortgages trade shorter. So Fannie Mae is still paying debt even after it received the cash flows from the mortgages. Even worse, it's paying debt at above market rates now that rates went down since issuance. Callable agency debentures fix this problem by giving Fannie Mae the same option that borrowers have. As borrowers call their mortgages in (i.e. as they prepay them), Fannie can call its own debt by paying it off early. Fannie can now make sure the duration of its liabilities (its debentures) is matched by the duration of its assets (the mortgages it owns). I'd be happy to explain any other aspect of the mortgage bond market, if there's anyone out there who's interested.
- michaelneale 18y ago
  I am interested but still struggling to digest that... I will have to read it a few times.
- axiom 18y ago
  Can you recommend a good introductory book on the subject?
  - ctkrohn 18y ago
    EDIT: This primer from Goldman is a couple years old but still a great guide: http://www.classiccmp.org/transputer/finengineer/%5BGoldman%20Sachs%5D%20A%20Mortgage%20Product%20Primer.pdf http://www.classiccmp.org/transputer/finengineer/%5BGoldman%... As far as books go, there aren't any, unfortunately. I think it's because the mortgage-backed securities market is largely confined to professional investors and traders who learn everything on the job. Stocks are the opposite: it's dead easy to open an ETrade account and buy some shares, so there's a ton of information for individual investors. Lots of people use Fabozzi (http://www.amazon.com/Handbook-Mortgage-Backed-Securities-Frank-Fabozzi/dp/0071460748/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1215915490&sr=8-1 http://www.amazon.com/Handbook-Mortgage-Backed-Securities-Fr...) as a reference, but I'm not a fan... it's disorganized, not particularly well written, and doesn't provide much information on how the market works on a day to day basis. The Salomon book (http://www.amazon.com/Salomon-Barney-Mortgage-Backed-Asset-Backed-Securities/dp/0471385875/ref=sr_1_1?ie=UTF8&s=books&qid=1215915811&sr=1-1 http://www.amazon.com/Salomon-Barney-Mortgage-Backed-Asset-B...) is popular too, but I've never read it.
jey 18y ago
I don't understand the whole "too big to fail" idea. They say that the collapse of a large institution would have a domino effect through the rest of the banking world, but how does it ever get that bad to begin with? If a particular institution is getting too big, shouldn't the other players want to hedge against its failure to protect themselves against the low-probability but high-cost situation in which a really big bank fails? Is this a situation where the market would behave like that in the ideal case (with perfect information, instantaneous communication, unbounded computation, etc) but we end up with "too big to fail" banks due to some sort of inefficiencies that occur in practice? Or is this situation due to government meddling (bailouts, guarantees, etc)? Or are these swings just due to humans acting emotionally/irrationally (e.g. in response to scare mongering news stories)? This is just a total guess, but to me it seems like it gets this bad partly because of a feedback cycle between inefficiencies of real-world markets and government meddling. The players in the real world markets don't have perfect information and instantaneous communication, so they end up not balancing their potential payoffs against the risks. The government (or central bank, whatever) steps in to rescue the system when the situation gets bad by propping up failing banks. Sounds good so far, but the problem is that this effectively functions like a zero-cost insurance policy and insulates the banks from some of the true risk of their investments. This encourages the banks to take riskier investments, since they get part of the risk paid for for free. Now you've got a positive feedback loop: banks take riskier investments due to gov't guarantee, gov't steps in when the investment goes bad, banks gain confidence in gov't bailout and make more even worse investments, rinse & repeat. It also seems like the governmental "insurance policy" encourages the kind of interdependency where one bank's failure can bring down other banks. It's more likely that the banks can collect on the insurance policy if many of them go down at once, but if only one bank is in trouble it's more likely that the government will just allow that one bank to fail. (I'm not proposing a conspiracy theory; I'm just saying that this "insurance" shifts the banks' costs/benefits towards mutual dependence and reduces the attractiveness of pursuing diverse/unconventional strategies.) OK, that's my half baked hypothesis -- what's the real explanation?
- breck 18y ago
  It could be that banks are unique in that a failure at one could cause consumers throughout the economy to irrationally panic, which could cause lead to a feedback cycle where a drop in confidence leads to a drop in economic activity leads to a drop in confidence etc.. In this case then due purely to chance(because even if a bank took adequate risk measures, they could still fail due to a freak event) the economy could spin into a recession without this "government insurance policy". It could be that all the top dogs on Wall Street and at the Fed are buddy-buddy, and don't want anything terrible to happen to each other, so they watch each other's backs. (Similar to how foreign rulers sometimes allow their deposed enemies to go into "exile", to hopefully win some good karma should they themselves ever become deposed). It's probably not either of these. I don't know. I don't think anybody does.
ajkirwin 18y ago
Am I the only person who wishes they WOULD fail? It seems like it's the only thing that would scare these massive companies into taking less risks.
- ctkrohn 18y ago
  If Fannie and Freddie fail and shut down, you will not be able to get a mortgage for the next several years. This is not an exaggeration. Mortgage lenders depend on the ability to sell their mortgages to Fannie Mae; your average lender doesn't have enough resources to keep all of them on its balance sheet. A huge number of investors buy the mortgage backed securities Fannie Mae issues because it's one of the biggest, most liquid, most transparent, and safest markets in the world. (And traders like me depend on it for their livelihood...) If that market disappeared, mortgage lending in the US would freeze.
  - ajkirwin 18y ago
    What, so people.. might start to use smaller providers, or perhaps as things used to be, make agreements with the sellers themselves in a kind of rent-to-buy agreement? Good lord, whatever will happen. Poor, POOR traders. Frankly, I could give less than two shakes on whether you depend on it for your livelihood. It's besides the point. Their primary business is to help people get homes. Or at least, it should be. Not to make money for traders.
    - ctkrohn 18y ago
      Ah yes, the difficulty of sarcasm over the Internet. All kidding aside, you're absolutely right that Fannie and Freddie shouldn't care about whether banks earn money trading mortgage bonds. I didn't mean to imply that banks, traders, or any other mortgage market participants deserved special treatment from the government, because they don't. Fannie Mae, Freddie Mac, and to a lesser extent Ginnie Mae play an important role in the mortgage market, and it's worth thinking twice before saying they should be allowed to go under. The market in their mortgage-backed securities (MBS) has led to substantially lower mortgage rates, to easily refinanceable mortgages, to a wide variety of types of mortgages: fixed year mortgages of all time periods, ARMs, balloons, etc. And while things were certainly taken too far, the government mortgage agencies allowed many deserving homeowners to take out mortgages that individual banks wouldn't have been willing to give. I don't think it's in the best interest of the country to go back to the old model of mortgage origination. That being said, I do think that Fannie and Freddie should really change the way they do business. Right now they perform two roles: that of a monoline (i.e. an insurance company), and that of a REIT. The monoline is what's important: by buying mortgages, taking a cut of the monthly payments as an insurance premium, and then packaging the mortgages in easily tradeable securities, they promote a smoothly functioning mortgage market. The REIT part is where they borrow money at extremely advantageous rates and invest it in their own MBS, like the original article talked about. The idea behind letting them operate as a REIT is that by buying large amounts of MBS, they would support their price, promote lower primary mortgage interest rates, and make housing cheaper for the nation as a whole. That's fine as far as it goes, but there should be stricter requirements on the size and riskiness of its portfolio. Earlier this year when private mortgage funds like Carlyle and others were blowing up, Fannie and Freddie should have been required to raise more capital and reduce purchases of new mortgages. But they weren't, and now we're in the mess we see now.
technolah 18y ago
This was predicted by Nicholas Nassim Taleb in the Black Swan. We're reducing the small bank losses in search for "stabilities" that group up all the losses in on fell swoop. Everything fails over time. Eliminating the small failures by making things too big to fail only creates the chance for things to fail in a biggest possible way. This isn't going to stop anytime soon.
- davidw 18y ago
  > This was predicted by Nicholas Nassim Taleb in the Black Swan. I got the impression that he firmly asserted that he was not in the predictions business.
- LogicHoleFlaw 18y ago
  That sounds remarkably like the "controlled burn" theory of forest fire management.
tokipin 18y ago
damn. for a moment i thought it was Sallie Mae melting down and i wouldn't have to pay my college debt any more T_T
noonespecial 18y ago
Lets use the laymens sniff test to figure out the level of WTF present in our system, using IndyMAC as an example. You have all your money in an IndyMac account. They hold your mortage. IndyMAC collapses prompting the FDIC to take them over and bail them out. What happens: You lose at least half (probably more) of all the money you have in the bank over $100k. They get a fat bailout, so long and thanks for all the cash. You are still expected to repay your mortgage in full. I know there's probably some logical explanation in financialese showing that this is the right outcome... But, come on, they lose your money and still demand to be repaid... WTF?!

71 points by bokonist 18y ago

To the finance & trading nerds out there: here's why callable debt is such a big deal. Like everything else in the mortgage bond world, it all comes down to prepayments. Borrowers have the option to prepay their mortgage by refinancing or simply by paying more than the minimum requirement. Because of the prepayment option, mortgages have a duration (defined as the average maturity of the cash flows, weighted by the present value of the cash flows) much less than their 30-year term. For example, the 10yr treasury note has a duration of just over 8 years, but FNCL 5.5 TBA mortgage futures (the most liquid type of mortgage-backed security) have a market-implied duration of around 5 years. Duration also measures the sensitivity of a bond's price to interest rates: for longer duration bonds, you are discounting the cash flows further back in time, so the rate at which you value future cash will have a greater effect on the present value. Think about it: if you are to receive $1000 in six months, it won't much matter to you if interest rates are at 1% or 10%. If the financial situation is relatively normal, $1000 in six months isn't worth much less than $1000 now. But a 30-year bond yielding only 1% is almost worthless (why would you lock up your money for 30 years at such a low rate), while one yielding 10% is extremely valuable. If prepayment speeds were static (i.e. if people always paid off their mortgages at the same rate), Fannie Mae could issue debt with 5-year duration (probably ~7yr maturity) at, say, 5%, and buy 30-year mortgages (also with 5-year duration) yielding 6%. They would thus make 1% per year, and on average they would pay off their own debt right when the borrower pays off his mortgage. Fannie and Freddie do issue debt in this form, referred to as bullets. The problem is that agency bullets have a very different convexity profile than mortgages. (If duration is the sensitivity of prices to interest rates, convexity is the sensitivity of duration to interest rates). Bullets have positive convexity: as interest rates go down, the bond has a longer duration. With low interest rates, future money isn't worth much less than money now. So when you are computing duration, the large cash flows towards the end of the bullet's life are dominant. Mortgages are exactly the opposite: they have negative convexity. As interest rates go down, a mortgage's duration gets shorter because borrowers refinance out of their old mortgage into a new one at a lower rate. If rates go up, the opposite happens. So suppose rates go up. The debt that Fannie issued trades to a shorter duration, but the mortgages they own trade longer. This means that on average, Fannie would have to pay off its debt faster than the borrowers pay off their mortgages. When Fannie's debt comes due before the mortgages, Fannie will have to refinance. And since rates went up in this scenario, it will have to refinance into more expensive debt than before. Now imagine rates go down. Fannie Mae's debt trades longer, and mortgages trade shorter. So Fannie Mae is still paying debt even after it received the cash flows from the mortgages. Even worse, it's paying debt at above market rates now that rates went down since issuance. Callable agency debentures fix this problem by giving Fannie Mae the same option that borrowers have. As borrowers call their mortgages in (i.e. as they prepay them), Fannie can call its own debt by paying it off early. Fannie can now make sure the duration of its liabilities (its debentures) is matched by the duration of its assets (the mortgages it owns). I'd be happy to explain any other aspect of the mortgage bond market, if there's anyone out there who's interested.

michaelneale 18y ago
I am interested but still struggling to digest that... I will have to read it a few times.
axiom 18y ago
Can you recommend a good introductory book on the subject?
- ctkrohn 18y ago
  EDIT: This primer from Goldman is a couple years old but still a great guide: http://www.classiccmp.org/transputer/finengineer/%5BGoldman%20Sachs%5D%20A%20Mortgage%20Product%20Primer.pdf http://www.classiccmp.org/transputer/finengineer/%5BGoldman%... As far as books go, there aren't any, unfortunately. I think it's because the mortgage-backed securities market is largely confined to professional investors and traders who learn everything on the job. Stocks are the opposite: it's dead easy to open an ETrade account and buy some shares, so there's a ton of information for individual investors. Lots of people use Fabozzi (http://www.amazon.com/Handbook-Mortgage-Backed-Securities-Frank-Fabozzi/dp/0071460748/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1215915490&sr=8-1 http://www.amazon.com/Handbook-Mortgage-Backed-Securities-Fr...) as a reference, but I'm not a fan... it's disorganized, not particularly well written, and doesn't provide much information on how the market works on a day to day basis. The Salomon book (http://www.amazon.com/Salomon-Barney-Mortgage-Backed-Asset-Backed-Securities/dp/0471385875/ref=sr_1_1?ie=UTF8&s=books&qid=1215915811&sr=1-1 http://www.amazon.com/Salomon-Barney-Mortgage-Backed-Asset-B...) is popular too, but I've never read it.

jey 18y ago

I don't understand the whole "too big to fail" idea. They say that the collapse of a large institution would have a domino effect through the rest of the banking world, but how does it ever get that bad to begin with? If a particular institution is getting too big, shouldn't the other players want to hedge against its failure to protect themselves against the low-probability but high-cost situation in which a really big bank fails? Is this a situation where the market would behave like that in the ideal case (with perfect information, instantaneous communication, unbounded computation, etc) but we end up with "too big to fail" banks due to some sort of inefficiencies that occur in practice? Or is this situation due to government meddling (bailouts, guarantees, etc)? Or are these swings just due to humans acting emotionally/irrationally (e.g. in response to scare mongering news stories)? This is just a total guess, but to me it seems like it gets this bad partly because of a feedback cycle between inefficiencies of real-world markets and government meddling. The players in the real world markets don't have perfect information and instantaneous communication, so they end up not balancing their potential payoffs against the risks. The government (or central bank, whatever) steps in to rescue the system when the situation gets bad by propping up failing banks. Sounds good so far, but the problem is that this effectively functions like a zero-cost insurance policy and insulates the banks from some of the true risk of their investments. This encourages the banks to take riskier investments, since they get part of the risk paid for for free. Now you've got a positive feedback loop: banks take riskier investments due to gov't guarantee, gov't steps in when the investment goes bad, banks gain confidence in gov't bailout and make more even worse investments, rinse & repeat. It also seems like the governmental "insurance policy" encourages the kind of interdependency where one bank's failure can bring down other banks. It's more likely that the banks can collect on the insurance policy if many of them go down at once, but if only one bank is in trouble it's more likely that the government will just allow that one bank to fail. (I'm not proposing a conspiracy theory; I'm just saying that this "insurance" shifts the banks' costs/benefits towards mutual dependence and reduces the attractiveness of pursuing diverse/unconventional strategies.) OK, that's my half baked hypothesis -- what's the real explanation?

breck 18y ago
It could be that banks are unique in that a failure at one could cause consumers throughout the economy to irrationally panic, which could cause lead to a feedback cycle where a drop in confidence leads to a drop in economic activity leads to a drop in confidence etc.. In this case then due purely to chance(because even if a bank took adequate risk measures, they could still fail due to a freak event) the economy could spin into a recession without this "government insurance policy". It could be that all the top dogs on Wall Street and at the Fed are buddy-buddy, and don't want anything terrible to happen to each other, so they watch each other's backs. (Similar to how foreign rulers sometimes allow their deposed enemies to go into "exile", to hopefully win some good karma should they themselves ever become deposed). It's probably not either of these. I don't know. I don't think anybody does.

ajkirwin 18y ago

Am I the only person who wishes they WOULD fail? It seems like it's the only thing that would scare these massive companies into taking less risks.

ctkrohn 18y ago
If Fannie and Freddie fail and shut down, you will not be able to get a mortgage for the next several years. This is not an exaggeration. Mortgage lenders depend on the ability to sell their mortgages to Fannie Mae; your average lender doesn't have enough resources to keep all of them on its balance sheet. A huge number of investors buy the mortgage backed securities Fannie Mae issues because it's one of the biggest, most liquid, most transparent, and safest markets in the world. (And traders like me depend on it for their livelihood...) If that market disappeared, mortgage lending in the US would freeze.
- ajkirwin 18y ago
  What, so people.. might start to use smaller providers, or perhaps as things used to be, make agreements with the sellers themselves in a kind of rent-to-buy agreement? Good lord, whatever will happen. Poor, POOR traders. Frankly, I could give less than two shakes on whether you depend on it for your livelihood. It's besides the point. Their primary business is to help people get homes. Or at least, it should be. Not to make money for traders.
  - ctkrohn 18y ago
    Ah yes, the difficulty of sarcasm over the Internet. All kidding aside, you're absolutely right that Fannie and Freddie shouldn't care about whether banks earn money trading mortgage bonds. I didn't mean to imply that banks, traders, or any other mortgage market participants deserved special treatment from the government, because they don't. Fannie Mae, Freddie Mac, and to a lesser extent Ginnie Mae play an important role in the mortgage market, and it's worth thinking twice before saying they should be allowed to go under. The market in their mortgage-backed securities (MBS) has led to substantially lower mortgage rates, to easily refinanceable mortgages, to a wide variety of types of mortgages: fixed year mortgages of all time periods, ARMs, balloons, etc. And while things were certainly taken too far, the government mortgage agencies allowed many deserving homeowners to take out mortgages that individual banks wouldn't have been willing to give. I don't think it's in the best interest of the country to go back to the old model of mortgage origination. That being said, I do think that Fannie and Freddie should really change the way they do business. Right now they perform two roles: that of a monoline (i.e. an insurance company), and that of a REIT. The monoline is what's important: by buying mortgages, taking a cut of the monthly payments as an insurance premium, and then packaging the mortgages in easily tradeable securities, they promote a smoothly functioning mortgage market. The REIT part is where they borrow money at extremely advantageous rates and invest it in their own MBS, like the original article talked about. The idea behind letting them operate as a REIT is that by buying large amounts of MBS, they would support their price, promote lower primary mortgage interest rates, and make housing cheaper for the nation as a whole. That's fine as far as it goes, but there should be stricter requirements on the size and riskiness of its portfolio. Earlier this year when private mortgage funds like Carlyle and others were blowing up, Fannie and Freddie should have been required to raise more capital and reduce purchases of new mortgages. But they weren't, and now we're in the mess we see now.

technolah 18y ago

This was predicted by Nicholas Nassim Taleb in the Black Swan. We're reducing the small bank losses in search for "stabilities" that group up all the losses in on fell swoop. Everything fails over time. Eliminating the small failures by making things too big to fail only creates the chance for things to fail in a biggest possible way. This isn't going to stop anytime soon.

davidw 18y ago
> This was predicted by Nicholas Nassim Taleb in the Black Swan. I got the impression that he firmly asserted that he was not in the predictions business.
LogicHoleFlaw 18y ago
That sounds remarkably like the "controlled burn" theory of forest fire management.

tokipin 18y ago

damn. for a moment i thought it was Sallie Mae melting down and i wouldn't have to pay my college debt any more T_T

noonespecial 18y ago

Lets use the laymens sniff test to figure out the level of WTF present in our system, using IndyMAC as an example. You have all your money in an IndyMac account. They hold your mortage. IndyMAC collapses prompting the FDIC to take them over and bail them out. What happens: You lose at least half (probably more) of all the money you have in the bank over $100k. They get a fat bailout, so long and thanks for all the cash. You are still expected to repay your mortgage in full. I know there's probably some logical explanation in financialese showing that this is the right outcome... But, come on, they lose your money and still demand to be repaid... WTF?!