Freddie Needs Some Competition
June 16, 2003
The stunning news that Freddie Mac, the large U.S. mortgage group, has dismissed its top three officers should alert all of us to the fact that the health of the U.S. economy is hostage to the decisions of only two corporate managements.
Freddie Mac and its larger sister company Fannie Mae are known as government sponsored enterprises (GSEs) because of their government charters and the special advantages they have been accorded by statute. Although their securities are not government-guaranteed, their links to the U.S. government have convinced investors that they will not be allowed to fail and this in turn has allowed them to become two of the four largest financial institutions in the U.S.
But it is not just the size of Freddie and Fannie that is important. They are also the dominant companies in the vital housing finance system, owning or guaranteeing almost half of all mortgages in this Dollars 6,000bn (Pounds 3,600bn) sector of the U.S. economy. If either of them were unable to buy mortgages from banks or other loan originators, and thus keep money flowing to the residential mortgage market, the housing market would be seriously disrupted--and with it the entire U.S. economy. Thus, the shake-up at Freddie raises the question of whether these two giant mortgage companies could create what regulators call "systemic risk"--the risk that a problem in one area will spread to and adversely affect the economy as a whole.
Only a few months ago, the Office of Federal Housing Enterprise Oversight, the safety and soundness regulator of the GSEs, published a report on whether they posed a systemic risk to the US economy. Although OFHEO concluded that there is no significant danger now because Fannie and Freddie are currently healthy, the report was noteworthy for pointing out that even today these enterprises are so large that an unresolved financial crisis affecting either of them could seriously damage the economy as a whole. And since they are growing rapidly--they have been doubling in size every five years for the past 25--the threat they pose grows along with them.
Needless to say, this would not be a problem if the secondary market for conventional conforming mortgages--the middle-class mortgages Fannie and Freddie alone are able to buy and sell--consisted of more than two gigantic companies.
A good example of how a diversified market remains stable under stress was the unexpected fall of Enron. In that case, one of the largest companies in the U.S. sank suddenly without a trace; but the highly diversified and competitive energy market continued to function satisfactorily. In finance, as in biology, diversity creates stability whereas lack of diversity creates the conditions for catastrophic collapse.
Unfortunately, the first reaction to Freddie Mac's problems, in Congress and elsewhere, is a call for better regulation. Leaving aside the question of whether any regulatory agency is able to make better decisions than the managements it regulates, this idea is wholly unrealistic. It reflects the seemingly irresistible urge in Congress to kick the can down the road instead of dealing with the real problem at hand.
As we saw in the savings and loan crisis of the early 1990s, efforts by a regulatory agency to limit an industry's growth are often met by congressional opposition if it will adversely affect consumers' housing costs. If OFHEO, or any other future "tougher" regulator, finding risky activities at Fannie and Freddie, tried to restrict their growth, it would be strongly opposed both by the two companies themselves and by those in Congress who might fear the resulting rise in home mortgage rates. This is opposition that no regulator is able to resist. The likelihood, then, is that Fannie and Freddie will be allowed to continue their risky course--as were the savings and loans--because Congress does not want to face the short-term result of a regulatory crackdown.
In addition, as we have seen in this case, OFHEO was not aware of the impending management shake-up at Freddie, or the depredations that apparently caused it, until shortly before these items were announced. This should show us that regulators are seldom made privy to the truly important events within a regulated company until it is too late to prevent problems. We still have repeated bank failures, for example, despite the fact that the bank regulators have been given authority to take "prompt corrective action" as banks exhibit weak capital or other problems.
In the end, the only protection against the systemic risk associated with Fannie and Freddie is their full privatisation--their complete separation from their many government benefits--so that a fully competitive and diversified secondary mortgage market will develop in the U.S. But since they will still be too big to fail, privatisation must be accompanied by their break-up into five or six smaller mortgage groups. In that way, if one or more of them encounters financial difficulties there will be no collapse in residential lending and no systemic effect on the general economy.
Peter J. Wallison is a resident fellow at the American Enterprise Institute.
Freddie Mac and its larger sister company Fannie Mae are known as government sponsored enterprises (GSEs) because of their government charters and the special advantages they have been accorded by statute. Although their securities are not government-guaranteed, their links to the U.S. government have convinced investors that they will not be allowed to fail and this in turn has allowed them to become two of the four largest financial institutions in the U.S.
But it is not just the size of Freddie and Fannie that is important. They are also the dominant companies in the vital housing finance system, owning or guaranteeing almost half of all mortgages in this Dollars 6,000bn (Pounds 3,600bn) sector of the U.S. economy. If either of them were unable to buy mortgages from banks or other loan originators, and thus keep money flowing to the residential mortgage market, the housing market would be seriously disrupted--and with it the entire U.S. economy. Thus, the shake-up at Freddie raises the question of whether these two giant mortgage companies could create what regulators call "systemic risk"--the risk that a problem in one area will spread to and adversely affect the economy as a whole.
Only a few months ago, the Office of Federal Housing Enterprise Oversight, the safety and soundness regulator of the GSEs, published a report on whether they posed a systemic risk to the US economy. Although OFHEO concluded that there is no significant danger now because Fannie and Freddie are currently healthy, the report was noteworthy for pointing out that even today these enterprises are so large that an unresolved financial crisis affecting either of them could seriously damage the economy as a whole. And since they are growing rapidly--they have been doubling in size every five years for the past 25--the threat they pose grows along with them.
Needless to say, this would not be a problem if the secondary market for conventional conforming mortgages--the middle-class mortgages Fannie and Freddie alone are able to buy and sell--consisted of more than two gigantic companies.
A good example of how a diversified market remains stable under stress was the unexpected fall of Enron. In that case, one of the largest companies in the U.S. sank suddenly without a trace; but the highly diversified and competitive energy market continued to function satisfactorily. In finance, as in biology, diversity creates stability whereas lack of diversity creates the conditions for catastrophic collapse.
Unfortunately, the first reaction to Freddie Mac's problems, in Congress and elsewhere, is a call for better regulation. Leaving aside the question of whether any regulatory agency is able to make better decisions than the managements it regulates, this idea is wholly unrealistic. It reflects the seemingly irresistible urge in Congress to kick the can down the road instead of dealing with the real problem at hand.
As we saw in the savings and loan crisis of the early 1990s, efforts by a regulatory agency to limit an industry's growth are often met by congressional opposition if it will adversely affect consumers' housing costs. If OFHEO, or any other future "tougher" regulator, finding risky activities at Fannie and Freddie, tried to restrict their growth, it would be strongly opposed both by the two companies themselves and by those in Congress who might fear the resulting rise in home mortgage rates. This is opposition that no regulator is able to resist. The likelihood, then, is that Fannie and Freddie will be allowed to continue their risky course--as were the savings and loans--because Congress does not want to face the short-term result of a regulatory crackdown.
In addition, as we have seen in this case, OFHEO was not aware of the impending management shake-up at Freddie, or the depredations that apparently caused it, until shortly before these items were announced. This should show us that regulators are seldom made privy to the truly important events within a regulated company until it is too late to prevent problems. We still have repeated bank failures, for example, despite the fact that the bank regulators have been given authority to take "prompt corrective action" as banks exhibit weak capital or other problems.
In the end, the only protection against the systemic risk associated with Fannie and Freddie is their full privatisation--their complete separation from their many government benefits--so that a fully competitive and diversified secondary mortgage market will develop in the U.S. But since they will still be too big to fail, privatisation must be accompanied by their break-up into five or six smaller mortgage groups. In that way, if one or more of them encounters financial difficulties there will be no collapse in residential lending and no systemic effect on the general economy.
Peter J. Wallison is a resident fellow at the American Enterprise Institute.
