Net new issues of agency securities turned negative in Q3 2005, as a result of the federal government’s crackdown on operations of Fannie Mae in late 2004.

(See: Flow of Funds Table F210, Agency- and GSE-backed Securities.)

This represents a withdrawal of over US$540 billion in the annual supply of these popular debt securities (the average net new issues from 1998 to 2003). This is part of the answer to Chairman Greenspan’s ‘conundrum’ as to why long-term interest rates did not rise as expected, in response to the Federal Reserve’s manipulation of short-term rates and the subsequent economic recovery.

In Q4 2005, the Office of Federal Housing Enterprise Oversight (OFHEO), classified Fannie Mae, the largest issuer of agency bonds, as ’significantly undercapitalized’. In December 2004, the Securities and Exchange Commission stated that Fannie Mae’s accounting practices, from 2001 to mid-2004, did not comply in material respects with accounting standards. As a result, Franklin Raines, Chairman and Chief Executive Officer of Fannie Mae, resigned.

Franklin Raines, a former high official in the Clinton administration, was in charge of Fannie Mae’s operations during the period 1998 to 2003, when issues of agency securities doubled and tripled from the previous annual levels of US$200 billion, as this graph shows:

Under government pressure to readjust operations to meet capital adequacy requirements and with Mr. Raines no longer at the helm, Fannie Mae was forced to cut back on new issues of its securities.

When a financial institution is under-capitalized, to meet capital-adequacy requirements it must increase equity or reduce debt, or both.

The substantial retreat of Fannie Mae from its aggressive role in mortgage securitization represented a victory for private financial institutions that had been lobbying for over a decade against government competition in this segment of the mortgage market.

Radical Change in the Market for Agency Securities

Prior to 2004, as the next graph shows, the market for agency securities had been diversified among financial institutions, foreign investors, and U.S. households, with the agencies themselves playing a major role as buyers. (This graph shows only portfolio operations, not operations as issuers.)

The ‘implied guarantee’ of the federal government on agency securities provided Fannie Mae with a competitive advantage over private institutions that had no government sponsorship.

By Q3 2005, government-sponsored agencies and most financial institutions were selling agency securities out of portfolio, while households and foreign investors had become the main buyers.

Without agencies as buyers and constrained from new issues, one might expect prices of agency securities to fall with the reduction in liquidity, pushing interest rates higher. However, there has been an significant countervailing force in the rapid expansion of the U.S. trade deficit. This deficit represents increased demand for bonds from the rest of the world. With the withdrawal of over US$500 billion in new issues from this market, bond prices were effected.

This entry was posted on Monday, February 13th, 2006 at 10:24 am and is filed under Agencies, Mortgages. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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