GSE Crisis and its implication - with focus on corporate governance
Fannie Mae and Freddie Mac, known as housing "GSEs", have a unique - federally chartered, shareholder owned - status. Although both are listed in the NYSE, investors believed that the federal government would bail them out in case of emergency because of various privileges. This widely accepted perception of "implicit guarantee" by the government allowed them to raise relatively low cost funds, contributing to the expansion of business volume to nearly half of 10 trillion US mortgage market. Their mission is stipulated in their respective charter to provide liquidity to housing market to expand homeownership among middle class American. They have two lines of businesses, namely portfolio investment and MBS credit guarantee. US MBS market expanded in order to alleviate disintermediation by S&Ls after 1970. Since the late 1990's, systemic risk had been discussed on their portfolio investment, and their regulator (OHFEO) imposed portfolio cap and other sanctions in 2004 after accounting scandal emerged on hedge accounting treatment as well as lack of internal control was apparent. But these sanctions were lifted gradually beginning 2007 to utilize GSEs to address housing correction triggered by subprime crisis. Further aggravating housing market, however, placed GSEs in the center of crisis in July 2008 when their stock price plummeted because the uncertainty of their business model escalated. Congress in coordination with Bush Administration enacted Housing and Economic Recovery Act (H.R. 3221) to expand the Treasury line of credit and endow authority for Treasury to purchase stock of GSEs. Based on this Act, GSEs are placed under conservatorship, but they are fulfilling their mission to sustain housing market until the market conditions warrants. Simultaneously, reduction of portfolio size was proposed after 2010 to limit systemic risk. But President Obama allowed GSEs to expand their portfolio by 50 billion each in his Homeowner Affordability and Stability Plan announced on February 18, 2009. There are similarities and dissimilarities between the GSE crisis and this financial crisis as a whole. This financial crisis highlighted the problems with regards to 1) risk management capability of individual institutions 2) executive compensation mechanism and 3) regulatory framework and regulatory arbitrage. 1) includes A) mismanagement of ALM in funding long-term assets with short-maturity instruments by SIVs and other vehicles resulting in the liquidity evaporation B) sudden increase of volatility in the price of illiquid products such as subprime-mortgage backed securities resulting in the market liquidity crisis and C) traditional credit risk which is the cause of all other problems. 2) relates to 1) in that compensation mechanism did not take accounts of the risks mentioned in 1) and allowed executives to pursue maximization of short term profit which was not commensurate with the longer term risk. 3) refers to the case of non-depository institutions including Lehman Brothers and AIG which was not supervised by FRB. In case of GSEs, 1-A) has been long discussed in the context of systemic risk. However, the GSE crisis was not caused by the mismanagement of ALM risk. Although GSE did not have stable retail deposit and depended on market for liquidity, their access to the capital market was not terminated, though adversely affected to some extent. This differs from Bear Sterns or Lehman Brother. As for 1-B), they incurred some loss from holding subprime PLS, but this loss was less crucial compared to the problems of 1-C) and 2. The main cause of the GSE crisis is the increase of credit risk triggered by the declining home price which spread to prime borrowers. Their executive compensation was linked to their profit as was the case of many large financial institutions as well. Their compensation mechanism caused accounting scandal around 2003. To some extent, they exposed themselves to riskier borrowers because they were required to support low and moderate income bracket in accordance with their affordable housing goal. With regard to 3), their regulator, OFHEO, was not capable of conducting as strict supervision as FRB and other banking regulators. But the key issue is why politics allowed them to grow "too big to fail" in the form of GSEs. This paper focused on the corporate governance of GSEs which contains fundamental ambivalent value of public policy implementation and maximization of return to private shareholders. We also analyzed the implication to the Japanese mortgage market which underwent significant structural reform incorporating US model.
Volume (Year): 6 (2010)
Issue (Month): 3 (March)
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