Previously published on November 2, 2022 in
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By Milton Ezrati, Chief Economist at Vested

As the Federal Reserve (Fed) drives up interest rates and the shadow of recession lengthens, concerns about financial vulnerabilities naturally rise. Declines in stock and bond values matter in this regard, but they constitute well-defined risks. It is the undefined risks that create the greatest danger of panic and financial failure. One of these centers on the practices of Washington’s two mortgage giants, the Federal National Mortgage Association (FNMA), Fannie Mae, and the Federal Home Loan Mortgage Corporation (FMCC) Freddie Mac – epicenters of much of the trouble in the 2008-2009 financial crisis.

Back in 2008-2009, both these giants almost went bankrupt. They have in fact operated under a federal conservatorship since. Back then the problem was the proportion of questionable credits in the mortgages they acquired from banks and other mortgage lenders and subsequently used to package into bonds that they then sold to the investing public. These were the so-called “sub-prime” mortgages that politicians encouraged Fannie and Freddie to buy and private lenders to extend. Because the conservatorship is doing its job and insisting on better credit quality, sub-prime is not much of a problem today. Instead, the issue concerns the guarantees used by these giants to promote the sale of their mortgage packages.

Largely because people remember the problems that arose in 2008-2009, Fannie and Freddie have frequently attached to their bonds a promise to repay investors should the mortgages included in the package fail. It is a kind of insurance. The problem is that these promises are not subject to the usual safeguards offered by insurance protocols. Instead, Fannie and Freddie have outsourced the default risk to private investors through what are called “credit-risk transfers” (CRTs). In return for a premium, these private firms issue a promise to pay in the event of failure. But because of the lack of normal insurance protocols, there are no assurances that these investors can pay should the mortgages fail. The CRTs are, in other words, much like the credit default swaps (CDSs) that caused so much trouble during the 2008-2009 crisis.

Much like those CDS, these CRTs constitute and undefined financial risk. No one can assess whether those masking the assurances can pay, and so no one can tell where failure might spread. Back in 2008 and 2009, uncertainties about who could or could not meet their obligations stymied the trading and contracting on which finance depends. Because of that the financial risks deepened the economic downturn of that time and delayed the economy’s ultimate recovery. Some today fear the same with the CRTs – that the impending recession will go deeper than it otherwise might and last longer.

Fears of default in a developing recession have prompted some who had entered CRT arrangements with Fannie and Freddie to sell out and have prompted others to avoid CRTs altogether. The premiums offered to cover losses have accordingly risen, and rapidly. They are now verging on almost 10% of the underlying amount of the mortgage package, a spread of some 6.75 percentage points above treasuries of comparable maturity, almost twice the spread of earlier in the year.

To be sure, the risk implicit in such high premiums may be overstated. Some close to the market contend that today’ s premiums implicitly anticipate a rerun of the 2008-2009 crisis. Though anything is possible, matters now are hardly as precarious as they were then. Credit qualities are far superior to what they were before that crisis and all financial institutions are better capitalized than they were then. Fannie and Freddie indicate that CRTs exist on some $60 billion of the mortgage debt they have packaged and sold. That is a large number but still a contained proportion of the $4.5 trillion in mortgages that the two giants have outstanding. Indeed, some bold investors claim that the now high premiums more than justify taking the risk and have begun actively entering the CRT market. Many others, however, are staying away, a fact to which the rise in premiums testifies.

Under the sway of these concerns and the danger should problems develop, it is strange that regulators have done so little to put guide rails on instruments like CRTs and CDSs. After the 2008-2009 crisis, Washington showed so much desperation to guard against a recurrence of the experience that Congressed passed the massive Dodd-Frank financial reform act. It intruded into just about every aspect of finance. It should have been easy simply to insist on insurance protocols on insurance-like instruments, such as CDSs and CRTs. But for all the flurry of activity in the aftermath of the crisis, nothing was done about these sorts of instruments. Now, even if on balance there is less to worry about than in 2008-2009, they present one more risk as the nation fights inflation and stands on the brink of recession.

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