Dimensions: 6'' x 9'' 120 pages AEI Press  (Washington) Publication Date: September 2004 Paperback ISBN: 0844741906 Price: $ 20.00 Add to Cart   Examination Copies

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September 2004
Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks: Why and How
By Peter J. Wallison, Thomas H. Stanton, and Bert Ely

In Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks: Why and How, AEI's Peter J. Wallison argues that tighter regulation cannot protect the taxpayers and the economy generally from the risks created by these government-sponsored enterprises (GSEs), and that privatization-eliminating all vestiges of their government backing-is the only viable solution. The legislative program outlined in this book shows that the goal of privatization can be achieved without disrupting the mortgage market and without leaving the privatized GSEs as the dominant players in the business of residential finance. In addition, the book contains an innovative proposal for a residential finance system that, without any government backing, may be able to produce lower mortgage- interest rates than those now offered by Fannie and Freddie.

The privatization plan and associated legislation were developed for AEI by Thomas H. Stanton, a Washington, D.C.-based attorney and the author of Government-Sponsored Enterprises: Mercantilist Companies in the Modern World (AEI Press, 2002). The plan and associated legislation for a new mortgage financing system were developed by financial consultant Bert Ely, a longtime and highly respected student of the residential finance markets and coauthor with Wallison of Nationalizing Mortgage Risk: The Growth of Fannie Mae and Freddie Mac (AEI Press, 2000). An introduction by Wallison summarizes both plans and explains why regulation, no matter how strict, will not be sufficient to control the risks that the GSEs create. Moreover, the introduction points out that the GSEs contribute so little to residential finance that there is minimal justification for their continued existence and no reason for the government or the taxpayers to take any significant risk by sustaining them, even as regulated entities. Wallison is a resident fellow at AEI and the editor of Serving Two Masters, Yet Out of Control: Fannie Mae and Freddie Mac (AEI Press, 2001).

The Privatization Plan

The privatization plan for Fannie and Freddie begins with a complete termination of the authority of the two companies to purchase mortgages and mortgage-backed securities (MBSs) for their portfolios. Then, over a five-year period, Fannie and Freddie are required to liquidate their mortgage portfolios and pay off the associated liabilities. This will over time reduce their interest-rate risk, which is the principal risk they currently bear. To the extent that liabilities remain at the end of the five-year period, they will be defeased with U.S. Government securities.

To avoid disruption of the mortgage finance markets as Fannie and Freddie stop purchasing mortgages for their portfolios, the GSEs are authorized-for a period of six months after enactment of the plan-to continue securitizing mortgages by creating and guaranteeing MBSs. At the end of the six-month period, however, they must begin to transfer this function to one or more subsidiaries of a fully private sector (state-chartered) holding company. These non-GSE subsidiaries will function much as other companies function in today's "jumbo" mortgage markets, in which highly rated MBSs are created through structured finance arrangements rather than direct guarantees.

Because their residential finance databases are an important element of their market power, Fannie and Freddie will only be permitted to engage in business activity through their new holding companies-including the securitization of mortgages-after they have spun off to independent companies copies of their automated underwriting systems and the relevant mortgage market information in their databases. The independent companies established for this purpose will be authorized to license this technology and data to all potential users at market rates. In this way, the shareholders of Fannie and Freddie, who will be the shareholders of the spun-off companies, will be able to recoup the value of the automated underwriting technology and the databases, and the competitive playing field in the residential finance business will be leveled. Fannie and Freddie will be permitted to continue to use copies of this information that they will retain, and to transfer this information to their holding companies for use by their private-sector affiliates. Once permitted to engage in business activities, the holding companies of Fannie and Freddie will be able to pursue any financial or other activity permitted by the laws of their chartering state.

At the end of five years from the date of enactment of the plan, Fannie and Freddie will have ceased all operations as GSEs and defeased all remaining liabilities. At that point, their charters will automatically be terminated.
 
The privatization plan for the Federal Home Loan Banks (FHLBs) is very similar to that for Fannie and Freddie. Immediately upon the enactment of the privatization plan, they will be required to stop new lending for any maturity date that extends beyond five years from the date of enactment of the plan. All continuing lending must be collateralized, other loans and assets will be sold off over a five-year period, and all other activities terminated. As in the case of Fannie and Freddie, the FHLBs will be permitted to set up private-sector holding companies, to which they will be able to transfer their business activities. After five years from the date of enactment, the charters of all the FHLBs will be terminated, and any remaining liabilities defeased.

The Financing Plan

One of the most common objections to the privatization of Fannie and Freddie is that their elimination as government-backed enterprises will increase mortgage rates. The introduction to this book, however, shows that the benefits associated with the activities of Fannie and Freddie are very small and far out of proportion to the risks they create. For this reason alone, the privatization of Fannie and Freddie would be good public policy. Nevertheless, the elimination of Fannie and Freddie as dominant factors in the residential mortgage market makes it possible to develop another financing structure that could well provide homebuyers with lower interest rates without any government backing.
 
The financing plan achieves its savings by focusing on two elements of the current mortgage finance system that have the effect of increasing rates: the requirement that banks and their subsidiaries maintain a minimum leverage capital ratio as well as a minimum risk-based capital ratio, and the fact that--in part because of the regulatory capital requirements--under the current system virtually all mortgages must be documented by the originator for sale to third parties. The leverage capital requirement makes it more expensive for banks to retain mortgages than to sell them, and the costs associated with preparing mortgages for sale raise the interest rates that these mortgages must bear.
 
Accordingly, the financing plan proposes steps that will eliminate or reduce both costs, and calculations by Bert Ely demonstrate that these steps--neither of which creates any risk for the financial system or the taxpayers--have the potential to reduce mortgage interest rates below the level now offered by Fannie and Freddie, even with their implicit government backing.
 
Under the financing plan, banks and bank holding companies (BHCs) would be permitted to establish mortgage holding subsidiaries (MHSs) that would not be subject to the bank's or the BHC's leverage capital requirement. The capital invested in these subsidiaries would be deducted from the parent's capital, so that the absence of the leverage capital requirement would not substantially weaken either the capital position of the bank or the BHC. The elimination of the leverage capital requirement for MHSs would level the playing field between bank-affiliated companies and other investors in mortgages. MHSs, like other investors, would then be able to finance their acquisitions of mortgages in the capital markets, retaining the amount of capital the markets require for this activity. MHSs would not be permitted to take deposits. The plan contemplates that MHSs could use a financing structure called in situ securitization, in which the MHS will guarantee to investors the payment of principal and interest on the mortgages, and thus will not take the interest-rate risk that is the largest component of the risk on mortgage portfolios.

Because banks and BHCs, as mortgage originators, would be able to transfer the mortgages they originate to an affiliated MHS, they would not have to incur many of the costs--normally passed on to borrowers as "origination costs"--that are necessary for the mortgages to be sold to third parties. These include appraisal, title insurance, flood certification, termite inspection, application fee, credit reports, mortgage broker fees, government fees and taxes, closing and settlement costs, courier charges, and miscellaneous expenses. These costs can amount to as much as 50 basis points in additional interest over the life of a typical mortgage.
 
In connection with the financing plan, Ely calculates that Fannie and Freddie have a financing advantage over other financing sources of about 20 basis points, and that by eliminating the leverage capital requirement and the need for many if not all the origination costs associated with selling the mortgages to third parties--including Fannie and Freddie--banks and other originators, through use of the MHS vehicle, will be able to offer mortgages at rates that are lower than those now offered by Fannie and Freddie.

 This book summary is available in Adobe Acrobat PDF format.