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Recap and Release of the GSEs

Fannie_Freddie
Fannie_Freddie

The US Treasury department, reportedly is wrestling with a plan for the re-capitalization and re-privatization of the Federal National Mortgage Association (aka FNMA, aka Fannie Mae) and the Federal Home Loan Mortgage Corporation (aka FHLMC, aka Freddie Mac), two entities at the center of the $10 trillion US mortgage bond market. 

As a former mortgage bond salesman, Fannie Mae and Freddie Mac give me painful flashbacks. Their weird past, and current status, represent one of the last unresolved issues of the 2008 mortgage crisis.

Since their $187.5 billion bailout and effective nationalization in September 2008, virtually all profits from Fannie and Freddie have been remitted to the US Treasury. The first quarter 2019 profits sent to the Treasury from Fannie and Freddie were $2.8 and $2.2 billion, respectively. Over the last 11 years, the firms have returned more in profit to the US Treasury in the form of dividends than they received in the bailout.

The Obama administration inherited the problem of these companies from the Bush administration in 2009 but could not figure out a way to move forward on a permanent resolution of their status. The Trump administration appears poised to announce their “recap and release” plan soon  – meaning raise enough private capital to make the companies fail-proof, and then turn the companies back into private entities again.

If they truly become private, well then, fine. But I have my doubts. My worry is they will revert back to the public/private hybrid monstrosities they were before the 2008 crisis. Bloomberg reported that Treasury Secretary Mnuchin would like the privatized companies to retain a government guarantee. Ugh. That’s the part I don’t like.

Forget Left Vs. Right

If we see the Fannie and Freddie problem and their resolution through the simple dichotomies of left/right, nationalized/private, socialism/capitalism – we’ve forgotten the weird history of these companies.

Like many policy issues when seen up close, the question of what to do with Fannie and Freddie defies easy characterization and solutions of the left versus right variety, or our ideological or aesthetic preference for more government or less government in our lives. 

Now, I like government. I think it does some wonderful things. I also like private companies. They also do wonderful things. Governments have their important functions, and private companies have their important functions. 

But also: What I don’t like are companies that straddle the hybrid line between public and private. What I really don’t like – and here’s what Fannie and Freddie always represent to me, as the worst of the 2008 crisis – is the hybrid company problem which, most succinctly stated, is “privatize the gains, socialize the losses.” By existing in their in-between status as “government-sponsored entities,” Fannie and Freddie were the ultimate “heads-I-win-tails-you-lose” companies.

In the 2000s, bond buyers loved owning Fannie and Freddie debt, known as “agency debt,” because of this in-between status. They were private, for-profit companies, sure, with private shares trading on the New York Stock Exchange. But they had the implicit backing of the federal government, because they had been originally Congressionally chartered and because they played such a systemically important role in the mortgage bond market. So they could issue more debt, at cheaper rates of interest, than any fully-private company. With that cheaper-than-anyone financing, they could build up larger-than-annual mortgage bond portfolios.

The federal government tried to claim, numerous times, that it didn’t fully backstop Fannie and Freddie agency bonds. They were “government-sponsored” but not “government guaranteed.” But of course in the end they did. It was a distinction without a difference.

Top executives paid themselves like rock stars more than $14 million and $12 million in 2006 and 2007 for Fannie Mae CEO Daniel Mudd, before he drove his government-sponsored entity off the cliff in 2008. Freddie Mac CEO Richard Syron collected nearly $20 million in 2007 before similarly destroying his company the following year. 

Those rock stars took over after both Freddie Mac CEO Leland Brendsel and Fannie Mae CEO Franklin Raines left within a year of each other, in 2003 and 2004, for inflating portfolio values and smoothing earnings in accounting scandals. 

Meanwhile, Washington has happy because DC regulators could periodically order the government-sponsored entities to loosen lending standards for new programs to encourage further home ownership, even among folks with dicey credit and fewer resources to weather any financial storm.

Government-guaranteed, but paid like the private sector! Totally malleable to government political pressure! Borrow at below-market rates to grow your balance sheet without limit. What’s not to love? Good times! Back in the 2000s National Public Radio played near-constant public service announcements that they were supported by Fannie Mae, ‘We’re in the American Dream Business” of homeownership. 

The Risks of the GSEs were known

Two years after I left Goldman’s mortgage desk in 2004, but two years before the mortgage crisis, I remember a dinner conversation in 2006 with a table full of bankruptcy trustees – folks who like to be alert to financial catastrophes and their causes. One asked my opinion of what the source of the next market crash would be. I confidently answered: Fannie Mae or Freddie Mac. They were too large and levered (indebted) and they ran the essential plumbing of the mortgage bond market. Any loss of confidence in them could trigger a tsunami of losses.

I mention this not to brag about my prescience, but rather to point out how obviously problematic Fannie and Freddie were to many people, years before the crisis blew up. The systemic risk posed by Fannie and Freddie wasn’t my original idea. Among people who understood the mortgage bond market it was a major fear. Hedge fund manager, author, and irascible financial philosopher Nassim Nicholas Taleb concluded similarly in his 2007 book The Black Swan: The Impact Of The Highly Improbable. He wrote in a footnote criticizing poorly-designed risk-management models, “…[T]he government-sponsored institution Fanny [sic] Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events ‘unlikely.’”

In the end, Fannie and Freddie didn’t cause the crisis. They were further kindling caught in the firestorm of housing-based over-indebtedness. After investors and executives collected the profits, the taxpayers were left with the liabilities.

Let’s hope Mnuchin’s Treasury Department comes up with a better plan for the future.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related post:

Book Review: Black Swan – The Impact Of The Highly Improbable, by Nicholas Nassim Taleb

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Book Review: Fooled by Randomness

Nassim Nicholas Taleb’s book should come with a warning on the cover: “If you are turned off by an arrogant, attacking, argumentative style, you will miss one of the best set of ideas on markets and investing in the last 20 years.”[1]

Now that I have given you, slyly, the same warning, let me emphasize the second part of my warning, because this book rewards the effort.

As in its successor, The Black Swan: The Impact of the Highly Improbable, Taleb tears down unexamined assumptions about the patterns we see in the world.  Similarly, Fooled by Randomness
hews to my preferred ‘How NOT To Invest’ rule on useful finance books, rather than the more typical airport bookstore “How To Invest” books that make me want to gag.

Taleb’s writing usefully addresses the question: When you consider investing in a successful money manager, posting consistently high returns over an impressive number of years, is that a brilliant investor or just the result of dumb luck?

Taleb walks the reader through a coin toss experiment which – for me at least – demolishes the typical treatment of the Financial Infotainment Industrial Complex’s celebration of “money manager brilliance,” in one clean hypothetical example.

Take 10,000 money managers, each of whom has a 50% probability of making $10K in a year, and a 50% probability of losing $10K in a year.  Any manager who loses $10K in a year gets tossed out of the pool of remaining managers.

At the end of the year, we expect approximately 5,000 money managers will be up $10K , while 5,000 money managers will permanently leave the pool of money managers.

When we run the game for a second year, 2,500 managers remain, each of whom has had a string of 2 good ‘up’ years.  After three years we have 1,250 managers, after four years we have 625 managers, and after five years we have 313 managers.  In Taleb’s experiment, these 313 managers have managed to post 5 brilliant years in a row, (with no down years!), although we know this is due to the pure dumb luck of the experiment.

As Taleb points out, and we know instinctively from the way the Financial Infotainment Industrial Complex works, these lucky 5-year managers will be hailed for their incisive minds, their vigorous yoga regimen, or their humble and strict upbringing.  If they then stumble in the next year, the Financial Infotainment Industrial Complex will point to the outdated approach of their investment thesis or the moral dissipations of their early success.  Or whatever.  The real truth is, as Taleb says, their luck changed more than they changed.

From a random dumb-luck cohort of investment managers, we can produce, consistently, a number of successful winners (3% in his example, over 5 years) who will receive undeserved accolades, even as their success appears to show a non-random seeming, statistically improbable, string of successes.

It’s easy to parody Taleb’s argument as ‘it’s all luck,’ but it’s more difficult, and more profitable, to examine ways in our own personal and financial lives in which we ascribe too much causality to random events and random markets.

In the simplest but most profound sense, about 99%[2] of the conversations I have or hear about investing, even (especially!) among serious people, invoke causality instead of luck, and see patterns instead of randomness.  We say the word ‘investing’ but we really mean, unknowingly, ‘gambling.’

A few other reasons I like Fooled by Randomness:

  1. I love the section midway through Fooled by Randomness in which Taleb describes the successful and personable “Carlos,” an emerging markets bond trader who, throughout a number of years, made $80 million for his bank, with nary a down quarter, only to blow a $300 million hole in his firm’s balance sheet during one traumatic summer of 1998 featuring the blowout of swap spreads, The Russian bond default, and the implosion of Long Term Capital Management.  Since I lived and breathed that market, and those years, with bond trading colleagues just like Carlos, I can relate.
  2. I serve as a fiduciary for a school whose endowment matters tremendously for the operation of the institution.  One of the never-ending challenges for any fiduciary who shares Taleb’s empirical skepticism is to keep returning to the role of luck and randomness in short and medium-term investment returns.  We want to be smart, but part of being smart, according to Taleb, is acknowledging that luck and randomness account far more for success than we prefer to believe.  We receive quarterly investment returns from our managers, but the value of that information is nearly zero.  It’s just noise.  As a natural corollary, decisions about money managers based on relatively short-term investment results should be made with a healthy dollop of skepticism.

 

Finally, one of the joys of Taleb is that he and his ideas engage productively in a dialogue with other thinkers.  Nate Silver’s The Signal and the Noise followed Fooled By Randomness in time but helps build a similar helpful skepticism about what we can know and not know from observable data and phenomenon.  The human tendency to see patterns and ascribe causality where none exists can be usefully counteracted through their thinking.

Taleb also explicitly attacks, among numerous others, a book I admire, Thomas Stanley’s The Millionaire Next Door.[3]  Taleb argues, correctly, that Stanley’s methodology crumbles in the face of statistical logic.[4]  I agree with Taleb on the statistical critique, while I also believe in Stanley’s conclusions and advice on how to conduct one’s personal and financial life.

One can be right for the wrong reasons, as well as wrong for all the right reasons, as I imagine Taleb would heartily agree.

 

Please also see my review of Nicholas Nassim Taleb’s Black Swan.

Please also see my review of Thomas Stanley’s The Millionaire Next Door

Please see related post: All Bankers Anonymous Book Reviews in one place.

[1] I read Fooled by Randomness when it first came out in 2005.  Since then I’ve often reflected on how difficult a job Taleb’s editor must have had.  Given the final product, earlier drafts must have been even more outrageously full of slashing critiques of all the idiots and frauds Taleb perceives everywhere.  In the forward to the second edition, Taleb acknowledges both his slashing style and his editor’s attempts to tone him down.  True to form, he argues his idiosyncratic style makes for better reading.  In a weird way, I agree.  But at least you’re now forwarned.

[2] I’m rounding down, to be conservative.

[3] I’ll review that one on this site soon.

[4] Stanley attempts to draw conclusions about ‘how to be millionaire’ based on surveys of millionaires.  His first problem is that he’s only interviewing a sample of millionaire ‘winners,’ so we really cannot know how many people followed the same exact path but ended up ‘losers.’  He has a flawed survivorship bias – similar to observing the universe of hedge fund managers today and drawing conclusions about the merits of hedge fund investing without taking into account the funds that did not survive.  Second, Taleb points out that the time period covered by Stanley’s study was a particular financial and economic moment in time of bull markets and asset price inflation.  A different time period might lead to an entirely different set of conclusions about ‘how to be a millionaire.’

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Book Review: Black Swan – The Impact Of The Highly Improbable

The “Black Swan,” of Nicholas Nassim Taleb’s title, describes an event that occurs completely outside expectations, has an enormous impact on future developments, and can be explained only in hindsight as predictable. Further, Taleb argues that despite the fact that we are blind to their imminent arrival ahead of time, Black Swans drive the world more than the visible, predictable patterns around which we typically organize ourselves.

Examples of Black Swans would include the European ‘discovery’ of the American continents, Eduardo Severin’s $20,000 Facebook investment becoming $2 Billion, the rise of modern weaponry for war, the 9/11 attacks, and the Great Credit Crunch of 2008[1]

But instead of looking for Black Swans, we seem to be hardwired to search for predictable patterns to understand our world.  The typical forward-looking models we create to make sense of the world tend to assume inertia and normal distributions.  We expect the future to remain within an expected range of previously observable or predictable outcomes.  Black Swans, however, all too often overwhelm our expectation for continuity, acting like a tsunami that wipes out all our careful planning.

If you find the Black Swan view of the world compelling, how would you then organize your life and organize your investments?

Taleb’s suggested approach to both is dominated by what he calls empirical skepticism, which may be otherwise understood as doubting everything, and trying your darndest to deal with the fact that what you should be worrying most about is the thing you haven’t yet conceived of.

What you should not do, however, is trust too deeply in established patterns, impressive-seeming back-ward looking models, or anything that depends on normally-distributed bell curves.

I founded my investment fund[2] in 2004 with a compelling investment thesis, based on observable phenomenon and solid experience.  From my mortgage bond sales seat at Goldman Sachs I could see clearly that we, and thousands of our colleagues and competitors, were engaged in a headlong rush to underwrite and securitize as much consumer debt as we could possibly create on a daily, weekly, and monthly basis.  A good portion of this debt inevitably would go bad, creating huge opportunities for distressed investors who knew how to find and profit from the distress of financial institutions.

I knew something about the default and recovery rates on this type of debt, and I knew about the profitability of purchasing debt when it became distressed. In sum, I knew that we were headed for a debt reckoning, and I knew I had to set up my fund and achieve scale in time to take advantage of that reckoning.  So far, so good.  My fund grew until 2008.

The Black Swan of 2008 made it clear that instead of focusing on what I knew, I should have profitably focused on what I didn’t know.  Fund of Fund Managers can have their capital wiped out in July 2008 and demand a 100% redemption, for reasons entirely unrelated to my fund.

Let’s just say the Black Swan of 2008 swatted aside all the things I thought I knew about distressed debt investing.  It was all the things I didn’t know that killed the fund.  Taleb would argue that I focused on all the wrong risks, and I have to say, in hindsight, he was right.

Market participants could contemplate a single large broker dealer like Bear Stearns going under in March 2008.  That’s not a Black Swan.  What was harder to contemplate and therefore qualifies for Black Swan status was the simultaneous insolvency in one week in September 2008 of Lehman, AIG, Fannie Mae, and Freddie Mac, followed within weeks by the likely insolvency of money market funds and every other major financial firm.

I know I’ve already written before that I don’t like ‘How To Invest’ books, preferring instead the ‘How Not To Invest,’ book as more profitable in the long run.  Most of Black Swan may be profitably read as a ‘How Not To Invest,’ as Taleb implicitly blows up the status quo investment approaches embraced by the mainstream Financial Infotainment Industrial Complex.

However, I would be remiss if I failed to mention Taleb’s interesting investing career, which practice closely reflects his Black Swan philosophy.  He co-founded and continues to consult with a fund called Universa.  Universa purchases ‘volatility’ and ‘tail risk,’ via a long options strategy.  In plainer English his fund traditionally purchases deep out-of-the-money calls and puts, resulting in a portfolio that loses a little bit of money in most years but makes a killing when the rest of the investment world blows up due to some unforeseen, volatile, Black Swan event.

A word of caution if you’ve never read Taleb:  His personality determines his writing style more than most authors.  In his first, well-known book, Fooled By Randomness, Taleb nearly undermines his key financial and philosophical points with his abrasive style.  He slashes through ideas and people he considers lazy or wrong, never lowering the decibel level on his critique.  He improved the tone in Black Swan to the level of merely an irascible professor, making him more readable than his debut effort.

 

Please also see my review of Nassim Taleb’s Fooled by Randomness.

Please see related post: All Bankers Anonymous Book Reviews in one place.

[1] Which of course occurred after the publication of Black Swan and did more than anything to cement the value of Taleb’s skeptical empiricism approach.  Black Swan is more readable but probably less profound than his earlier book Fooled by Randomness, which I’ve reviewed here.  His latest book Antifragile, Things That Gain From Disorder is on hold at my local library.

[2] Misleadingly labeled a ‘hedge fund’

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