EVENTS

Date:	Tuesday, April 26, 2005
Time:	9:00 AM -- 11:00 AM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

April 2005

Should Fannie Mae's and Freddie Mac's Mortgage and MBS Portfolios Be Capped, Reduced or Eliminated?

Following testimony by Alan Greenspan, key members of Congress have begun to focus on the retained mortgage and mortgage-backed securities portfolios of Fannie Mae and Freddie Mac as a major source of the risk to taxpayers and the economy. This promises to be the most contentious issue in the fight over new regulation of government-sponsored enterprises. Supporters argue that restricting Fannie Mae’s and Freddie Mac’s investments in mortgages and mortgage-backed securities will increase mortgage rates. Opponents argue that accumulating portfolio investments increases the risks the two companies create without significantly reducing rates. At an April 26 AEI conference, experts considered which of these views is more likely to be correct and how the issue is likely to play out on Wall Street and in Congress.

Dwight Jaffee
University of California-Berkeley

Fannie Mae and Freddie Mac are government sponsored enterprises operating within the U.S. mortgage market.  They have two business lines: one to create and then sell mortgage-backed securities (MBS) to capital market investors, the other to purchase and hold mortgages and MBS in their “retained mortgage” portfolios.  It has been increasingly recognized that the interest rate risk contained in the retained mortgage portfolios of Fannie Mae and Freddie Mac represents a serious threat to the U.S. financial system.
 
What replaces the retained portfolios?  Depository institutions (banks and thrifts) will be as important as capital market investors in replacing the retained portfolios.  Banks now have a 48-percent market share, compared with 56 percent in 1990.  So there is no issue with expertise to handle interest rate risk.  The Basel Committee on Banking Supervision will expand the incentive of all banks, foreign and domestic, to buy MBS.  In addition, bank deposit insurance is funded by the industry, not the Treasury, which creates industry-wide discipline.

What happens to U.S. mortgage rates?  As intermediaries, Fannie Mae and Freddie Mac are in principle replaceable with near zero impact on mortgage interest rates.  Interest rates, including mortgages, could actually fall if investors gain faith in the U.S. financial system as the retained portfolios decline.  Both theory and practice suggest any rate rise would be less than ten basis points.
 
What are alternative solutions?  Redesign the fixed rate, pre-payable mortgage.  Another option is to raise Fannie Mae’s and Freddie Mac’s capital requirements.  Higher requirements can create riskier behavior and therefore require a higher level of regulatory oversight.  Full privatization is also an alternative, but this would be difficult to implement without Fannie Mae’s and Freddie Mac’s cooperation.  Removing retained portfolios achieves the major benefit of privatization and is easy to implement.  The retained portfolios of Fannie Mae and Freddie Mac increasingly create unacceptable risks for the U.S. financial system.  The portfolios, and thereby their risks, are readily eliminated through an orderly repayment process.
 
Jason Thomas
Senate Republican Policy Committee

The fact of the matter is that the management of Fannie Mae and Freddie Mac were right:  the capital markets treat them as agencies of the federal government.  My simple proposition is that it is long past time for Congress to do so as well.  Otherwise we will just be chasing our tail: creating a new federal agency to regulate these shareholder-owned federal agencies. Why portfolio limits?  Given the evolution of credit markets generally, and the mortgage market in particular, it is difficult to see the rationale for the federal-sponsorship of large, highly-leveraged mortgage bond funds.  Perhaps such funds could have been justified when state and federal regulations limited interstate branching and geographic credit risk dispersion, and MBS had yet to reach today’s level of acceptance.
 
In fact, it seems that Fannie Mae’s and Freddie Mac’s portfolios have grown most rapidly at just the time at which the capital markets have become most able and willing to absorb their MBS and attendant interest and prepayment risk.  Fannie Mae’s and Freddie Mac’s transformation into mortgage bond funds is perhaps the best evidence we have that their decades-long endeavor to standardize loan documentation and promote mortgage securitization is complete.

This year Congress will have to decide whether to endorse this post-mission arrangement, or to reject it through the establishment of clear limits to the GSEs’ portfolios.  Without such limits, there can be no doubt that the GSEs will, at some point in the near future, resume the  exploitation of their agency status to displace private credit flows and assume more interest rate and prepayment risk.  Were they not intending to do so, I find it hard to believe they would commit so much in resources to protect their current status.
  
Unfortunately, I fear that the argument that will ultimately have the most impact on the Hill is that portfolio limits are “arbitrary.”  I can already envision members coming to the floor to ask why Congress is seeking to place arbitrary limits on the American dream.  Of course, any hard cap on portfolios, whether set in legislation or by a regulator, would be arbitrary.  But by not imposing such a cap, Congress would simply allow the GSEs to increase the value of their subsidy arbitrarily through the increased issuance of subsidized debt.

AEI research assistant Jessica Browning prepared this summary.