Issue #25 of Net Interest, and welcome to all new subscribers. Every Friday I distil 25 years experience of looking at financial institutions into an email that explores key themes trending in the industry. If you’re reading this, but haven’t yet subscribed, join over 8,000 smart, curious people by signing up now.
Financing the American Home
As a non-American there are many things I don’t understand about America.
They range from the big, like the electoral system, to the curious, like why anyone would want so much ice in a cold drink. And how tipping works. And why corporate bathrooms are never that nice, even on Park Avenue.
Most of all though, I don’t understand the most American of products: the 30-year fixed-rate fully prepayable mortgage.
On American streets, the product is everywhere. It makes up around 80% of an $11.3 trillion mortgage market. Yet, with the exception of Denmark, it doesn’t exist anywhere else in the world. Even baseball exists in more countries.
It’s easy to see why. From the consumer’s perspective, it’s an amazing product. It’s a simple loan that offers stable repayments, kept low because they are spread out over such a long period of time. Its kicker is a free option to prepay, which shields the borrower from interest rate risk. If rates go up, borrowers can commend themselves on a great bargain; if they go down, stay calm—the loan can be refinanced without penalty. Win/win.
All the characteristics that make it terrific for the consumer make it terrible for a traditional lender. Thirty years is a long time to have something sitting on your balance sheet, watching the credit risk compound. Especially something that’s loaded with as much interest rate risk as this. If it’s win/win for the consumer, somebody has to be on the other side of that trade.
Sustaining such a one-sided design clearly requires work. An entire ecosystem of complex financial instruments provides one layer of support.  But underneath that sits another: the US government, which now controls two-thirds of the market. By removing the credit risk and dispersing the interest rate risk inherent in long-term fixed-rate mortgages, the US government gives them life. As Bethany McLean says, they “accomplished something that Rumpelstiltskin would envy. They took the worst possible investment – a 30-year fixed-rate fully prepayable mortgage – and turned it into the second most liquid instrument in the world, just behind Treasuries.”
To many, the idea that the US, a beacon of the free market, should support its mortgage market so directly seems odd. The former Governor of the Bank of England, Mervyn King, once remarked: “You Americans are so strange. Most countries have socialised healthcare and a private market in mortgages. You have socialised mortgages and a private market in healthcare.”
Yet, go deeper into national psyche, and an explanation emerges.
It is said that the closest thing the English have to a religion is the National Health Service. If there was any doubt about that, it disappeared during the first lockdown, when the devout would ritually congregate on their doorsteps to cheer the NHS. An equivalent in America may be home ownership. From the 1940s through to the 1970s, consumerism built on the foundation of suburban home ownership had all the elements of a civil religion. Framed in this way, government support reflects a faith that renders it less strange.
The only problem is that the amount of government support is quite large and, when it comes to home ownership, agnostics are beginning to emerge. As we discuss below, government intervention began in the 1930’s, it shifted gear in the late 1960’s and it moved up a notch following the financial crisis in 2008. Today it represents the last piece of the last financial crisis yet to be addressed. It has been kicked down the road by two Presidents; it may take a third to resolve.
The Years Before the 30-Year Fixed-Rate Mortgage
The 30-year fixed-rate mortgage has only been around since 1948, based on a structure that was developed during the Great Depression. The American ideal of home ownership, however, has been around a lot longer.
The ideal of home ownership can be traced right back to colonial days, when a person who owned property was seen as a better citizen and a more noble and trustworthy person. Following independence, the founding fathers saw ownership of small plots of land as integral to the identity of the new nation as prosperous and democratic. “The small landowners are the most precious part of the state,” wrote Thomas Jefferson. Renters were stigmatised and denied rights, including – until 1860 – the right to vote in federal elections.
As Americans moved from farms into cities, they took the idea of property ownership with them. Land was abundant, habitable, accessible and cheap. Home ownership became a core part of what it was to be a citizen. As early as 1900, over 45% of families owned their own homes. Again, the idea was promoted from the very top of government. President Calvin Coolidge said: “No greater contribution could be made to the stability of the nation, and the advancement of its ideals, than to make it a nation of home owning families.”
To finance home ownership, families would take a loan looking nothing like the American mortgage of today. A family wanting to buy a Boston home for $3,000 (imagine!) would typically put down $1,500 in cash and borrow the rest on a three to eight year term at a rate of around 5.5%.  Payments would be interest-only and at the end of the term, the loan would either be repaid or refinanced. Data from the 1890 census shows that 29% of homes in the US carried an outstanding mortgage in that year.
The system worked well—until the Great Depression. The 50% loan-to-value built into mortgage structures wasn’t enough to absorb the collapse in house values that occurred at the beginning of the 1930’s, and lenders refused to refinance. Borrowers defaulted in droves. Between 1931 and 1935, lenders foreclosed on around 250,000 homes per year.
The New Deal
In response to the crisis, the federal government intervened, setting up a number of institutions to help. One of them – the HOLC (Home Owners’ Loan Corporation) – raised funds to purchase defaulted mortgages which it would then reinstate. To make them more affordable, it changed the terms, converting variable, short-term interest-only mortgages into fixed-rate, long-term (20 year) fully amortising mortgages that look closer to the American product of today. The advantage of the structure is that it would not need to be refinanced—borrowers could completely pay it off over 20 years. In total, the HOLC purchased and converted one million mortgages.
Because the government was not in the business of holding mortgages, it looked around to sell them on. It was confronted with two problems.
First, investors were nervous that these new-fangled loans would not get fully paid. So the government established the Federal Housing Administration to provide insurance. (Through its eligibility criteria, the FHA would help standardise mortgages across the country.)
Second, investors didn’t have the capacity to hold an instrument as long term as these new mortgages. To tackle that, the government needed to create a liquid secondary market on which mortgages could freely be bought and sold. It drafted legislation that provided for the establishment of privately-owned national mortgage associations to buy mortgages in the secondary market. To kick-start them, it even offered incentives. Yet no-one was interested. After four years of cajoling, the government was forced to go it alone. In 1938, it set up the Federal National Mortgage Association, known as Fannie Mae. Its role was to buy mortgages originated by banks and other lenders. The ability to get cash immediately for existing loans freed up mortgage makers to go out and make more loans.
Jesse Jones was a key figure in FDR’s clean-up operation during the Depression and I happen to have a first edition of his memoir. In it, he writes: “In setting up the Federal National Mortgage Association to work exclusively in the handling of FHA-insured mortgages, we again entered the mortgage field only after our offers to become partners with private capital had fallen on deaf ears.”
This reluctance of private capital to backstop the mortgage market would recur again. It stems partly from the risk involved (30 years is a long time) and partly because having established a foothold in the market, the government’s presence makes it difficult for private capital to compete. The same issues give the the government such a dominant share of the market today.
Back in the early 1940’s, the government’s intervention in the mortgage market may have begun out of necessity but it persisted because it fit neatly with the government’s pledge to foster home ownership. President Roosevelt repeated the mantra in 1942: “A nation of homeowners, of people who own a real share in their land, is unconquerable.”
By setting up Fannie Mae as an independent agency, the government nominally put it outside ‘the state’, but to all intents and purposes it was a state enterprise. The 2008 crisis made America’s socialisation of mortgages more transparent to people like Mervyn King, but it had been moving that way for 80 years. Sociologist Sarah Quinn argues that America uses indirect policy tools such as credit more than other governments a) to circumvent the diffused complexity of its political system and b) because American people are more likely to be suspicious of concentrated state power. So rather than operate a nationalised bank like in China, say, the US operates an indirect scheme of credit facilitation, but the end-result is similar. She writes, “the point is not to be laissez-faire so much as to profess a commitment to laissez-faire.”
A New Age of Prosperity
With the groundwork in place, the new government-backed mortgage market was able to help drive further increases in home ownership. After the Second World War, a new age of prosperity dawned, grounded in consumerism of families living in suburban detached single-family homes. The Housing Act of 1949 promised a “decent home and suitable living environment for every American family”. Between 1940 and 1960, home ownership increased from 44% to 62%, and outstanding mortgage debt grew from $36 billion to over $207 billion.
Fannie’s job was to buy mortgage loans in the secondary market. In 1948 the government abandoned plans to set up its ‘national associations’ and Fannie was the only game in town. That same year, the maximum term of a loan was raised to 30 years and the 30-year fixed-rate fully prepayable mortgage was born.
All was going well, until a crisis hit in the late 1960’s. The major originators of mortgages were banks and savings and loans institutions who would fund themselves by taking deposits. In 1966, interest rates rose and these banks suffered deposit outflows as depositors were able to get better rates in the market. This restricted their capacity to fund mortgages.
The crisis occurred alongside two other issues. One was a problem of poor living conditions for African Americans. The other was Vietnam and the impact that was having on fiscal resources. The solution was to restructure Fannie Mae. It was sold to private investors with a mandate to promote liquidity and stability in the secondary market for mortgages and to provide mortgage credit throughout the nation. By taking it private, the government was also able to remove its debt – a number that would grow materially over the following decades – from its balance sheet. In 1970, Freddie Mac was set up to create a market competitor for Fannie Mae.
As savings and loans institutions came under mounting pressure, Fannie and Freddie were structured to pick up share. Home ownership was still being promoted—President Bill Clinton said, “Homeownership, home building, home sales, home mortgages, and home values will once again be the rising tide that lifts all of America’s boats.” The home ownership rate fluctuated between 63% and 66% from the end of the 1960’s through to the end of 1990’s.
Except now, as shareholder-owned companies, new stakeholders had been brought into the frame.
Single-Family Mortgage Debt Outstanding. Source: Compass Point
When it was sold to private shareholders, Fannie Mae was vested with a couple of privileges. First, it was allowed to operate on very low levels of capital. Second, its debt carried the implicit guarantee of the US government. These privileges freed its balance sheet of constraints, an opportunity the company grabbed. It conducting its core business of guaranteeing the timely payment of interest and principal on its mortgages well enough. But by exploiting its implicit guarantee to raise cheap funding, Fannie and Freddie were able to make money investing in mortgage-related assets. One estimate suggests that in the 1990s, around 40% of their profits derived from the implicit government support. At the peak, they had $1.6 trillion such assets on their balance sheets.
Throwing shareholder interests, government interests, homeowner interests, debtholder interests and management interests into a single cocktail created a heady mix. And all this to sustain the 30-year fixed-rate fully prepayable mortgage.
Underpinned by so little capital, it all came to a head in 2008.
Fannie and Freddie’s losses were mounting and so over Labour Day weekend, the government was called into action to resolve them. The only problem was they were too big to nationalise. Having pushed Fannie out to private shareholders in order to get its debt off the budget in 1968, the government couldn’t afford bringing its enlarged balance sheet back on in 2008.
So instead, the government embarked on what it calls a conservatorship. And in trying to optimise across so many interests, it ended up tying itself in knots.
Conservatorship was supposed to be temporary. The press release accompanying the move said that it was “a statutory process designed to stabilize a troubled institution with the objective of returning the entities to normal business operations.” To shore up their finances, the US Treasury offered each of Fannie and Freddie up to $200 billion of capital support in exchange for warrants over ~80% of common stock and some senior preferred stock. The support carried a 10% cash dividend.
Each quarter, as credit conditions deteriorated, Fannie and Freddie would draw down on the Treasury’s support. Except that they would have to draw a little more in order to pay the 10% dividend on top. So on one day in August 2012, the government decided to revise the 10% dividend and insist that Fannie and Freddie hand over all their profits instead, in what became known as a ‘net worth sweep’. (I remember the day well since I was long junior preferred stock in the entities on the basis that they would one day recapitalise and restore some value; following announcement of the net worth sweep, they cratered.)
The net worth sweep created a vicious catch-22. By preventing the entities from building capital to restore their solvency position, they would forever be unable to exit conservatorship. It also looked a little bit like an asset grab. The timing coincided roughly with the trough in Fannie and Freddie fortunes; from then on, they were back to making money. All told, the government put in $190 billion of capital but has taken out $300bn in dividends and profit sweep. A former Treasury secretary even said, “As a practical matter, it’s what has helped us to reduce our overall deficit.” Owning a monopoly business can do that!
Bethany McLean comments in her book, Shaky Ground, The Strange Saga of the US Mortgage Giants: “When you mix together the government and the private market, they interact in ways that are hard to predict in advance and difficult to untangle even after the fact.”
Nevertheless, eight years later, we are getting closer to an untangling. Last year, the government proposed a new capital rule for Fannie and Freddie, paving the way for the pair to be “recapitalised and released”. Lots of work still needs to be done. The net worth sweep needs to be unwound; a decision needs to be made on how to treat the Treasury’s senior preferred stock; litigation brought by frustrated investors needs to be settled; a fee for the government guarantee needs to be agreed.
And then private capital has to be raised—up to $240 billion of capital. Even if the Ant Group IPO had gone ahead (see below), an IPO of Fannie and Freddie will put it in the shade.
The question remains though: why? It seems like an awful lot of bother to sustain the 30-year fixed-rate fully prepayable mortgage. The product has already been at the scene of two financial crises and requires massive amounts of government intervention to service. The very nature of private-public structures has been shown to be rife with conflict. Yet in spite of it all, the ideal of home ownership remains one of the few areas of broad agreement in American politics, and the 30-year fixed-rate mortgage has become synonymous with it. Even if home ownership has fewer believers today than forty years ago, its apparatus is too unwieldy to dismantle.
 The 30-year fixed-rate fully prepayable mortgage has spawned a range of derivative instruments used to hedge its interest rate risk. Byrne Hobart describes how given the market’s size, hedging leads to excess volatility in underlying Treasuries.
 On the West coast, rates were higher, perhaps 10%. One of the outcomes of nationalising the mortgage market was the creation of a nationally more uniform market.
This piece draws on the work of Bethany McLean (Shaky Ground: The Strange Saga of the US Mortgage Giants) and Sarah Quinn (Government Policy, Housing, and the Origins of Securitization, 1780 - 1968) as well as my own experience as an investor in Fannie Mae and Freddie Mac junior preferreds (2011 - 2019). Byrne Hobart also addresses the issue here.
More Net Interest
I’ve said before that the invisible asymptote on fintech growth is regulation. For Ant Group the scale is much larger, but this week the company bumped up against its presence. Following the cancellation of its IPO, the top securities regulator in China said that “changes in fintech industry regulations will have a ‘huge impact’ on Ant Group’s operational structure and profit model”.
One such change is the proposed introduction of a 30% loan retention requirement which would make the business a lot more capital intensive – and volatile – than its current model, where only 2% of loans are on the balance sheet. It also shifts the narrative around valuation. No longer a pure platform, Ant’s credit business begins to look more like China Merchant Bank (100% loan retention), which trades on a multiple of 9.4x earnings.
Another suspected change is that Alipay may have to be split from the rest of the group, which undermines Ant’s flywheel thesis.
The news reflects an important trend. Ant has for a long time been keen to distance itself from financial services and cosy up with tech, first by categorising itself as a “techfin” and then by dropping “Financial” from its name. However, regulators are equally keen for this not to happen and can be quick to drag the company back under their purview. It’s the same all over the world. Having spent many years post the financial crisis looking inwards, financial regulators are now looking outwards.
The Oldest Bank in the World
Visit the beautiful town of Siena in Italy and on your way to the Piazza del Campo you will likely pass by the head office of Banca Monte dei Paschi di Siena, the oldest bank in the world. It may not be independent for much longer. The bank has a whole heap of problems—low capital levels, thin margins, a lot of legal risk. The Italian Government owns 68% but is required to sell its stake by the end of next year. This week it was reported that the Italian Treasury has offered Unicredit various incentives to buy the bank. These incentives include a plan to absorb the cost of 6,000 staff cuts (28% of Banca Monte dei Paschi di Siena’s total).
On his earnings call Unicredit’s CEO was reticent: “No M&A assumptions.”
But with a forced seller and a shortage of buyers, this could be another step towards the consolidation of the Italian banking market, where the top 5 players have a smaller share than in other European banking markets. Like in Spain, it is becoming clear that you don’t need that many bank branches—although the big one on the way to the Piazza del Campo is likely to stay.
The Department of Justice filed an antitrust lawsuit yesterday, challenging Visa’s acquisition of Plaid. Visa is a global behemoth with a market cap of $385 billion, 70x the valuation it places on Plaid ($5.3 billion); it had revenues of $23 billion in the last calendar year, 230x the revenues of Plaid ($100 million). So what’s going on?
It seems that policymakers have learned from their mistakes with Big Tech. Ben Thompson of Stratechery argues that Facebook’s acquisition of Instagram was the greatest regulatory failure of the past decade. Regulators waved it through because at the time of acquisition, Instagram had only 30 million users and $0 of revenue, so it looked like very little of a competitive threat.
Yet, emails released in the Big Tech antitrust hearings this year reveal that Facebook did see Instagram as a threat. “Instagram can hurt us meaningfully without becoming a huge business,” wrote Zuckerberg.
The DOJ case alleges that Visa is similarly fearful of Plaid’s potential. It regards Visa as a monopolist in online debit services, with a durable market share of 70%. It proposes that ‘pay-by-bank’ is a new form of online debit service that threatens Visa’s monopoly and which “Plaid is uniquely positioned to offer.” The case highlights comments from Visa’s Vice President of Corporate Development and Head of Strategic Opportunities, who said, “I don’t want to be IBM to their Microsoft”.
Based on its press release, Visa’s defence seems to hinge on Plaid not being a payments company. But that could reflect the present state, rather than a future state which is where the DOJ reckons Plaid is heading. The napkin art drawn up by the Vice President of Corporate Development and Head of Strategic Opportunities suggests they think Plaid could be heading there, too.