Investors worried about both interest rate and political risks have driven down the shares of the US mortgage groups Fannie Mae and Freddie Mac close to their 52-week lows. Political risk is probably an insoluble problem, but the companies are voluntarily taking on the serious interest rate risk that investors fear.

Unfortunately for US taxpayers, Fannie and Freddie have done the rational thing for companies that the markets regard as being government-backed, just as the savings and loans organisations did in the late 1980s. They have placed the risk of loss on the government, while keeping the gains. Now investors are worried by the political risk that the government's response will be to weaken its implicit backing for the two institutions. Fannie and Freddie were established to add liquidity to the mortgage markets by purchasing mortgages from lenders, thus allowing them to make more residential mortgage loans. For many years after their creation, they simply purchased and held mortgages. In doing so, they took the interest rate risk associated with holding a fixed income asset--a mortgage--while funding it with variable rate liabilities. The S&Ls were ultimately destroyed by a similar mismatch.

By 1981, Fannie and Freddie had begun to use the new technology of securitisation and were issuing mortgage-backed securities as a supplement to the purchase of mortgages for their portfolios. Mortgage-backed securities represent shares in the stream of principal and interest that is paid into a pool of mortgages held by a trustee. Fannie and Freddie guaranteed that holders of securities would receive the principal and interest paid on mortgages in the pool as long as it lasted.

Such securities were an important innovation because they separated the interest rate risk and the credit risk associated with holding mortgages. When Fannie or Freddie guaranteed the income stream from a pool of mortgages, they were taking only the credit risk--the risk that homeowners would not be able to pay their monthly mortgage obligations. Investors in the securities took the interest rate risk--the risk that market interest rates would rise or fall relative to the interest paid on the mortgages in the pool.

But the fees that Fannie and Freddie received for guaranteeing mortgage- backed securities were trivial in comparison with the profits they could earn by holding mortgages. In the latter case, their government backing allowed them to borrow inexpensively in the capital markets and profit on the spread between the interest rate on the mortgages they held and their low cost of funds. When they issued mortgage-backed securities, they no longer received the interest paid on the mortgages. It therefore made financial sense to take interest rate risk by holding such securities as well as issuing them. The bond markets were largely indifferent because they saw Fannie and Freddie as government-backed.

As a result, since the mid 1980s, Fannie and Freddie have followed a policy of repurchasing mortgage-backed securities for their own portfolios. Today, they together hold more than Dollars 1,000bn in mortgage-backed securities--more than a third of all these securities outstanding--and have borrowed more than Dollars 1,000bn to carry the portfolio. This has helped to create the interest rate risk that has worried investors and some in the US government.

Is it necessary for Fannie and Freddie to buy mortgage-backed securities in order to lower mortgage interest rates, in line with their role in expanding home ownership. Many economists say that the answer is no. When Fannie and Freddie borrow in the capital markets and then use these funds to purchase mortgage-backed securities from investors, they are not affecting mortgage interest rates. It is simply a money-for-money swap.

So if Fannie and Freddie are not lowering interest rates by purchasing these securities, why are they doing it? The question answers itself. The taxpayers, through the generosity of Congress, have offered Fannie and Freddie a great deal: heads you win; tails we lose. You can take interest rate risk by repurchasing your own mortgage-backed securities; if you earn substantial profits from your government support, you can keep them; if the market moves against you and you suffer losses, we will cover them.

The way to address this situation is to prohibit Fannie and Freddie from holding mortgages or mortgage-backed securities in their portfolios. That would reduce the risks they are taking on the taxpayers' account, but would not significantly affect mortgage rates. With the concern about the risks being taken by Fannie and Freddie, it is worth considering. 

Peter J. Wallison is a resident scholar at AEI.