Housing Finance: “Understand What Broke, Keep What Worked, Discard What Didn’t”

Annaly Capital Management is a real estate investment trust (REIT) that manages a portfolio of adjustable-, floating-, and fixed-rate mortgage-backed securities. The REIT “represents the secondary market investors who have historically provided the majority of the capital to the $11 trillion mortgage market.” In that capacity, he recently provided testimony and documentation to the House Financial Services committee on “The Future of Housing Finance—A Review of Proposals to Address Market Structure and Transition.”

Michael A. J. Farrell is the Chairman and CEO of the firm. He lobs out sharp tongued commentary and critiques of mortgage, securitization and housing related issues in his blog, Annaly Salvos on the Economy and Markets.

I found his overview of the crisis succinct and informative:

“The liquidity that Fannie Mae and Freddie Mac provide, both through their MBS guarantees and through their own balance sheets, has been an important component of this system, and not just for the conforming borrower. Indeed, a conforming borrower has generally paid a lower rate than a jumbo prime borrower, but the conforming mortgage rate also serves as an effective benchmark for other mortgage rates.

It has not been a perfect system, however, and its flaws became most evident beginning in the first decade of this century. These flaws are well‐documented and include (but are not limited to):

• Fannie Mae and Freddie Mac, as private companies with public policy charters, served two masters. They pushed for profitability for shareholders to the detriment of their government charters by increasing their leverage and lowering their own underwriting standards. In the end, they achieved their charter objective, but they failed both masters.

• Mortgage originators ignored prudent underwriting standards and unleashed a flood of affordability products on unwitting and unqualified borrowers.

• Mortgage borrowers misunderstood or ignored the risks of the affordability products.

• The financial engineers on Wall Street created CDO and SIV structures that fed unprecedented demand and embedded leverage on leverage.

• Ratings agencies used flawed models, included perpetual home price appreciation assumptions, to improperly rate the different cash flow tranches.

• Investors in both the senior tranches (including the GSEs) and the junior tranches exercised poor judgment in trusting that others on the assembly line (originators, rating agencies, underwriters) did their jobs responsibly.

• The socialization of credit risk around the globe infected virtually every financial institution.

The key to overhauling housing finance in America is to understand what was broken, then keep what worked and discard what didn’t.

He obviously is not an unbiased participant, but he is knowledgeable, and provide insight. The full PDF is worth reading.


Input on Reform of the Housing Finance System
Michael A.J. Farrell, Chairman, Chief Executive Officer and President
Annaly Capital Management, Inc.
U.S. House of Representatives Committee on Financial Services, July 21, 2010
“The Future of Housing Finance—A Review of Proposals to Address Market Structure and Transition”

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