Dimensions: 6'' x 9'' 158 pages AEI Press  (Washington) Publication Date: March 2002 Hardcover ISBN: 0-8447-4160-4 Price: $ 30.00 Add to Cart   Examination Copies

March 2002
Government-Sponsored Enterprises: Mercantilist Companies in the Modern World
By Thomas H. Stanton

This book sounds a note of alarm about the generally weak financial supervision and low capital standards of the major government-sponsored enterprises. Author Thomas H. Stanton's earlier book on GSEs, A State of Risk (HarperCollins, 1991), helped persuade policymakers to create a new government financial regulator for Fannie Mae and Freddie Mac. Yet, the government remains largely unable to address the financial risks inherent in these highly leveraged institutions.

Stanton is an attorney, the chairman of the Standing Panel on Executive Organization and Management of the National Academy of Public Administration, and a fellow of the Center for the Study of American Government at Johns Hopkins University. A summary of the book follows. 

What happens when the government charters and subsidizes a few private companies to serve public purposes in competition with other private firms? This comprehensive study of U.S. government-sponsored enterprises (GSEs) tells the story of a well-intentioned idea that has outlived its usefulness. Now that government has allowed them to become multibillion dollar or even trillion dollar financial institutions, it lacks the strength either to direct the activities of GSEs to higher priority public purposes or to privatize most of them and remove their special government support.

The GSEs are a case study in flawed organizational design. A peculiar legal framework determines much of the behavior of GSEs. They represent an old institutional form that has taken on new vitality because of political strength that protects their government subsidies and allows them to expand in the marketplace. This book traces their origins to mercantilist enterprises of the sixteenth century, contrasts investor-owned and cooperative GSEs, and examines design issues, activities, size, legal attributes, charter powers, the fulfillment of public purposes, and the quality of oversight.

The book follows up its comprehensive examination of the six enterprise--Fannie Mae, Freddie Mac, the Federal Home Loan Bank System, the Farm Credit System, Farmer Mac, and Sallie Mae--with an analysis of the life cycle of these instrumentalities and of exit strategies now that they are coming or have come to the end of their usefulness.

The six GSEs are financial institutions. They possess financial, structural, and legal attributes that provide many lessons for policymakers and policy analysts. The analysis of GSEs can shed light upon issues of institutional design and the need for policymakers to pay increased attention to the structure and quality of the organizations that they attempt to create through the legislative process.

What Is Wrong with GSEs?

GSEs are hybrid institutions that combine characteristics of public and private organizations. Their ownership and control is private, but government provides them with significant subsidies, including tax and regulatory advantages, and permits them to fund their activities with an implicit government guarantee, almost as if they were part of the government. The GSEs operate in markets where their non-GSE competitors do not receive such government benefits.

The two dominant GSEs, Fannie Mae and Freddie Mac, are the largest financial institutions in the country. They have used their federal subsidies to double in size every five years, and each now funds over a trillion dollars of home mortgages. Their federal support also means that the companies are immensely profitable, with returns on equity above 20 percent every year. Their profitability contributes to political influence that the companies use to keep their federal oversight weak. Thanks to favorable legislation, they operate with greater financial leverage than virtually any other financial institution in the country. In terms of helping to provide affordable housing and to enable home ownership among minorities, the two GSEs lag behind the rest of the mortgage market. In the contest between private profits and public purposes, profitability has triumphed.

For policy analysts who believe that history helps to explain current institutional behavior, the study of GSEs can offer special insights. The lineal ancestors of today's GSEs, including the first and second Banks of the United States and even earlier institutions from mercantilist times, also manifested the peculiar mixture of public purpose and private profitability that motivates GSEs in today's world. Because of the size and long life cycles of some GSEs, patterns of GSE behavior also can illuminate issues of governance. This book explores the contrast in behavior and evolution between investor-owned GSEs and GSEs that are structured to be ooperatives.

This is a book about institutional design and the structure of the GSE as a special type of institution that is authorized, defined, and shaped by law. GSEs are instruments of government policy, and they provide instructive case studies of the consequences of design choices for the strengths and limitations and life cycles of a particular type of institution. The design of public institutions can be understood in terms of discrete sets of issues:

• the organizational form of the institution, including whether the organization is public, private, or some form of hybrid;
• the nature of the subsidies that the government provides to the institution as a tool of government;
• the public purposes of the institution;
• relevant history;
• the institution's governance structure and life cycle;
• the exit strategy for the institution to pursue when it has served or otherwise outlived its usefulness as an instrument of public policy.

The Plan of the Book

The book is organized into seven chapters, including a general overview of GSEs and one chapter devoted to each of the six sets of design issues listed above. The first chapter provides an overview of the size and activities of the GSEs today, their institutional behavior, and their origins. The second chapter begins the analysis of legal attributes and organizational form of the GSE and the important differences between GSEs and other private companies. This chapter introduces the legal concept of the instrumentality of government, a nongovernmental organization that serves public purposes.

GSEs are a special type of instrumentality, and the third chapter examines the most distinctive feature of GSE status, which is the implicit backing that government provides for GSE obligations. This is a unique form of subsidy, and it is difficult for government to administer, compared to other more direct types of subsidy.

Thanks to the perception of implicit government backing, GSEs operate with higher financial leverage and less capital than other firms in similar lines of business and thus have a significant competitive advantage in the marketplace. A private company such as a commercial bank r an insurance company may not be able to compete against the special subsidies and preferences that government provides for a GSE. The perception of government backing of GSE obligations removes market discipline and requires that government supervise safety and soundness of the GSEs.

The fourth chapter looks at the public purposes of the individual GSEs as reflected in their enabling legislation. The chapter reviews charter powers of major GSEs and the process by which those powers have expanded over the years. The chapter assesses the quality of government oversight of the public purposes that GSEs serve and discusses the impact of new technologies upon the authorized activities of GSEs under their charters.

The fifth chapter traces the peculiar legal framework of GSEs back to its origins in the first and second Banks of the United States and, before that, the Bank of England. The legal structure of the GSE is a vestige of mercantilist Europe, when the sovereign would grant a special charter to a company to undertake special activities. The behavior of GSEs today, and especially their incentives to try to protect their favorable legal status by dominating the political process, resembles similar behavior by earlier ercantilist institutions.

The sixth chapter provides a case study of the consequences of institutional design for the life cycles of GSEs. It begins with an analysis of the tension between private profits and public purposes that GSEs were designed to serve. Then the chapter contrasts two investor-owned GSEs, Fannie Mae and Freddie Mac, with the third housing GSE, the cooperatively owned Federal Home Loan Bank System. While an investor-owned GSE attempts to increase profitability by expanding into new markets, a cooperative such as the Federal Home Loan Bank System can be limited by the power of its members and the need to serve their interests. Finally, the seventh chapter discusses issues relating to the design of an exit strategy for GSEs, including lessons that can be derived from 1996 legislation to restructure Sallie Mae, remove its federal sponsorship, and end its status as a GSE.

How the Government Lost Control

The book concludes that GSEs did provide valuable benefits in the past, but the special-purpose GSE charter is no longer suited to today's fast-moving financial markets. Markets are changing so quickly that the GSE becomes a long-term institutional solution for a problem that may be quite transitory. Indeed, to the extent that the GSEs have improved markets through their innovations and development of economies of scale, they have diminished the need for government to continue to develop such markets through special forms of intervention and subsidy such as a GSE.

The GSE is an important instrument of government policy. But as Lester M. Salamon, who contributed the foreword to this book, has pointed out elsewhere, "The key is to fit the tool to the nature of the task." Absent serious institutional shortcomings in both government and the private markets, the government-sponsored private company seems to fit poorly in today's marketplace. To the extent that a GSE is chartered to serve purposes defined by law, it can lack the flexibility of a completely private financial services firm that is free to define and redefine its activities and lines of business in response to market signals. To the extent that the GSE wields market power, it can impede the emergence of more efficient competitors and innovations. To the extent that the GSE uses its access to government subsidies to expand its market power, the GSE imposes burdens on market competition that would not be present if government provided comparable subsidies without tying those benefits and preferences to a handful of institutions.

The poor fit is made worse to the extent that government has largely abdicated to the GSEs themselves the power to affect the public benefits and public costs of GSEs. In the early stages of Fannie Mae and Freddie Mac, government kept fairly tight control over the organizations. In Fannie Mae's case, the GSE until 1989 was limited by its charter to providing "supplementary assistance" to the secondary mortgage market; also, the U.S. Department of Housing and Urban Development (HUD), Fannie Mae's designated government supervisor, had authority to approve new activities of the GSE in advance. Freddie Mac was governed by a board of three government officials who also served as members of the Federal Home Loan Bank Board.

The law has now changed to reduce government control. Today, Fannie Mae's charter authority has expanded to permit the GSE to "respond appropriately to the private capital market," and HUD no longer has prior approval authority over Fannie Mae's activities. Shareholders, rather than government officials, now control the Freddie Mac Board of Directors, and in general Freddie Mac is subject to the same weak oversight as Fannie Mae. These changes took place in the context of a legislative environment distracted by larger events such as the savings and loan debacle and financial difficulties with major HUD programs; the government seemed virtually unaware of the extent to which it was losing control over the largest GSEs. The book provides numerous other examples of the expansion of the scope and extent of permitted GSE activities.

For those reasons and in contrast to Stanton's position earlier in his career, the book recommends that the federal government devise an exit strategy for the GSEs. Not all readers may agree with that policy conclusion, but the book is intended to serve all readers regardless of their view of such ultimate questions by providing a guide to the legal and institutional framework that shapes GSEs and their behavior.