Government Policy and Financial Market Stability
The Case of Fannie Mae
About This Event

What is the government's role in stabilizing the financial system? Academic researchers, practitioners, and policymakers often argue that financial markets require unique forms of government intervention given their importance to the wider economy. Many also believe that government policies designed to reduce financial market instability and the threat of systemic risk are desirable. There is, however, substantial disagreement concerning the appropriate policy tools and their effectiveness. At this conference, experts on financial market regulation will discuss two recent papers that identify possible societal benefits of the current regulatory regime and Fannie Mae's role in that regime. Participants will identify and discuss factors that affect the size of these benefits relative to their costs.

Agenda

8:45 a.m.

Registration

9:00

Introduction:

Kevin A. Hassett, AEI

9:15

Panel I: Systemic Risk and Regulation

Presenter:

Eugene Ludwig, Promontory Financial Group, LLC

Discussants:

Robert Shapiro, Brookings Institution and
Sonecon, LLC
Peter J. Wallison, AEI

Moderator:

Randall S. Kroszner, AEI and University of Chicago

10:45

Panel II: The Government's Role in Promoting Financial Sector Stability

Presenter:

David Gross, Lexecon, Inc.

Discussants:

Desmond Lachman, AEI
Peter Niculescu, Fannie Mae

Moderator:

Kevin A. Hassett, AEI

12:30 p.m.

Luncheon Address:

Franklin D. Raines, Fannie Mae

1:30

Adjournment

Event Summary

February 2004
Government Policy and Financial Market Stability: The Case of Fannie Mae

What is the government's role in stabilizing the financial system? Academic researchers, practitioners, and policymakers often argue that financial markets require unique forms of government intervention given their importance to the wider economy. Many also believe that government policies designed to reduce financial market instability and the threat of systemic risk are desirable. There is, however, substantial disagreement concerning the appropriate policy tools and their effectiveness. At a February 6 AEI conference, experts on financial market regulation discussed two recent papers that identify possible societal benefits of the current regulatory regime and Fannie Mae's role in that regime. Participants identified and discussed factors that affect the size of these benefits relative to their costs.

Panel 1: Systemic Risk and Regulation

Eugene Ludwig
Promontory Financial Group, LLC

The issue of systemic risk has been a central point of debate between all branches of government and the private sector. There are five key points that should be recognized to further the debate about government regulation and systemic risk in the financial market: First, governmental action, or by contrast inaction, has produced most, if not all, systemic events in the financial market. Second, government management of systemic risk has improved considerably since the Great Depression, which prompted advanced supervision and regulation of financial institutions with improved transparency, highlighted the need for a monetary policy that maintains liquidity in times of market stress, and exposed the need for capital requirements and deposit insurance. These improvements have significantly reduced the risk of systemic events in the United States. Third, excessive focus has been placed on large financial institutions such as Fannie Mae and Freddie Mac as sources of systemic risk, as such institutions may actually decrease overall systemic risk through advanced risk management and efficiency advantages. Fourth, the extension of governmental regulation and supervision to unregulated institutions that offer risks similar to regulated institutions should be considered. Fifth, unregulated institutions offer potentially greater risks than regulated institutions, which are subject to close regulation and supervision.

Robert Shapiro
Brookings Institution and Sonecon, LLC

The analysis of financial market regulation and stability should begin with the consequences of systemic financial market crises, rather than with a precise focus on systemic risk. Indeed, the financial sector communicates its performance more directly to the economy-at-large than other sectors, as other sectors rely so heavily on the performance of financial institutions.

While there is truth to the argument that improved government regulation has decreased the risk of systemic crises, regulation alone cannot counter such crises that are the direct result of political crises. Beyond such cases however, which can be resolved through other devices such as responsive monetary policy, regulators have proven adept at minimizing risks when not subjected to structural political constraints. It is important to note, however, that regulators have proven their success in dealing with those threats to financial stability with which they are familiar.

Beyond a lack of familiarity, a host of recent problems in the financial sector, including the Enron scandal and concerns over governance of the New York Stock Exchange, have also proven challenging to regulators, for such problems arose from distortions in the normal conduct of business in the financial sector rather than through exogenous factors or shocks. Indeed, as many of the institutions at issue are self-regulating, it is not clear how government regulation helped head off a systemic crisis.

Consolidation in the financial sector has not increased systemic risk. Indeed, it is not the objective magnitude of financial institutions such as Fannie Mae that presents systemic vulnerability, but rather the highly integrated nature of the financial sector more broadly. The argument for stricter regulation focuses on preventing initial shocks to financial institutions such as Fannie Mae from happening at all, and thus minimizes the impact on the integrated financial system.

Peter J. Wallison
AEI

The paper presented by Eugene Ludwig is likely the best argument against the notion that Fannie Mae or Freddie Mac poses a systemic risk. In examining the issue of systemic risk, it is important to begin with a precise definition of what a systemic event is so that appropriate steps can be taken to minimize the threats that such events pose. Systemic events are shocks that begin within the financial sector and spread to the wider economy. The Ludwig paper goes further in its usage of this term, for example, labeling the Great Depression a systemic event, an unsupportable application of the term, as no single shock has been identified as triggering the Great Depression. Imprecise definition of systemic events detracts from effectively focusing on those factors that present viable systemic threats.

Ludwig's paper details a number of improvements in government policy that have no doubt reduced overall systemic risk. These tools-such as enhanced supervision, strengthened capital requirements, deposit insurance, and increased transparency-that have proven successful in mitigating overall systemic risk, however, have not been properly applied to Fannie Mae or Freddie Mac. If these regulatory advances mentioned in Ludwig's paper are responsible for minimizing systemic risk yet have not been applied to Fannie Mae, one is left with the conclusion that Fannie Mae must therefore pose the threat of systemic risk. With debt obligations in the trillions, the risk posed by Fannie Mae and Freddie Mac is all the more credible.

Panel 2: The Government's Role in Promoting Financial Sector Stability

David Gross
Lexecon, Inc.

There are two principal forms of guarantees made by the government to the financial sector. First there are explicit guarantees, which can be in the form of deposit insurance or FHA/VA loans, and which enjoy backing by the full faith and credit of the U.S. government. There are also implicit guarantees made by the government that are perceived in the market to be inherently uncertain and reflect a nonzero probability of government involvement. These implicit guarantees are frequently denied by government and those parties, such as government-sponsored enterprises like Fannie Mae, that are perceived by the financial sector to enjoy such guarantees.

One potential side-effect of such guarantees is the moral hazard problem, which can cause investors to loan to firms at low interest rates even if that firm is unsound or provide incentive for under-capitalized firms to take excessive risks. Outside experts such as Standard and Poors and Moody's have assessed Fannie Mae and have determined they have strong supervisory and regulatory regimes in place to properly contain the moral hazard problem and limit risk to the financial sector generally. With such containment, the costs and benefits of such guarantees are low. These guarantees, however, offer insurance against contagion and shocks, an important safeguard that cannot be offset by any benefits derived from eliminating the current system of guarantees.

Desmond Lachman
AEI

There is justifiable concern with the potential cost to taxpayers should the government have to exercise its guarantees to Fannie Mae. The moral hazard problem cannot be dismissed in light of the questionable regulatory regime applied to GSEs, as described earlier by Peter Wallison. The sheer size of Fannie Mae and Freddie Mac's debt position-now in the trillions-warrants concern, particularly in light of the fact that they hold 39 percent of the U.S. Treasury market. Indeed risk is further posed by these institutions by their significant, on the order of 33 percent-mortgage-backed securities and the extent to which they are leveraged. Furthermore, these risks are made all the more worthy of concern by their degree of concentration.

While there is no indication that systemic crises are imminent, current conditions do not preclude the possibility. With 40 percent of the current account balance financed by foreign central banks and a significant domestic budget deficit, the likelihood of a potential systemic shock, while low, cannot be dismissed as negligible. Furthermore, the notion that hedging can mitigate the risks posed by GSEs such as Fannie Mae is also flawed, as hedging is inherently speculative and therefore susceptible to miscalculation. With the size of the Fannie Mae's and Freddie Mac's balance sheets, the risks they pose, and considering the fallibility of hedging, risks to taxpayers are a matter of concern.

Peter Niculescu
Fannie Mae

One of the principal strengths of the GSEs is the liquidity of the secondary mortgage- backed securities that they trade. Indeed, during stresses in the financial markets, such as those witnessed in the aftermath of September 11, mortgage-backed securities continued to trade with a high volume of liquidity, a direct result of the institutional framework of GSEs, and a result that ultimately benefited homeowners with the availability of stable and low cost mortgages.

It is important to note that implied guarantees go beyond GSEs in scope and indeed translate benefits to the banking sector through the Federal Home Loan Bank system. While it is effectively impossible to determine what a subsidy to GSEs would be absent governmental connections with the tools currently available, it is possible to order such implied guarantees. This is because benefits of these guarantees accrued through trading agency debt should also be present in the banking sector, again through the FHLB system. Because banks have other options of finance such as deposits, it can be concluded from the relative liability structures of banks versus Fannie Mae that implicit guarantees can be more costly to banks than to GSEs. Therefore a move away from GSEs as intermediaries in the secondary mortgage market to other liabilities such as deposits in the banking sector could have unpredictable consequences.

In examining the liability structure of GSEs such as Fannie Mae, bondholders in such institutions should be comforted by the predominance of senior debt versus other liabilities. This is because the high ratings given to institutions such as Fannie Mae by credit agencies, Moody's for example, reflect a tendency to not default. This stability, coupled with the ability to recoup losses, a characteristic not shared by liabilities such as deposits, which can be lost to deposit insurance, is beneficial to bondholders.

Luncheon Address

Franklin D. Raines
Fannie Mae

Any policy discussion about Fannie Mae must begin and end with a concern for the needs of the home-buying family. Fannie Mae provides a mechanism to utilize private capital in achieving the public good of homeownership. The financing of America's homes is a serious issue, and any policy discussion thereof must be equally serious.  There are several theories regarding Fannie Mae's role in the secondary mortgage market, and they must be addressed. First, there is the theory of an implied guarantee of Fannie Mae's liabilities in the event of its failure. The meaning of the term "implied guarantee" is not clear, with no knowledge of who provides such a guarantee or how such a guarantee might work. Furthermore, Treasury Secretary John Snow has testified that there exists no implied guarantee to Fannie Mae.

A second theory asserts that the assumed implied guarantee acts as a subsidy. Fannie Mae receives no federal funding, and in fact, if Fannie Mae's charter were revoked, the net effect would result in a loss of tax revenue for the government, nullifying any positive fiscal impact derived from discontinuing the subsidy-if Fannie Mae were to have one. It is necessary to note, however, that Fannie Mae's charter does provide important benefits, but these have providing the public good of low cost mortgages in mind. Fannie Mae, through its charter, is able to market debt in large volumes, increasing value and lowering the yields that Fannie Mae must pay. Furthermore, by law, Fannie Mae must match its capital to its risk, which in the case of mortgage debt, is considered by some to be 50 percent less risky than other assets held by banks. Therefore, it is not unreasonable for Fannie Mae to hold comparatively less leveraged capital than banks. Fannie Mae also minimizes costs through high credit ratings and other mechanisms.

A third critique of Fannie Mae is that its large debt liability poses a threat to the financial system at large. Other financial institutions, such as Citigroup, which is federally chartered, have greater outstanding debt liabilities, yet they enjoy explicit guarantees unlike Fannie Mae.

A fourth concern is that Fannie Mae and Freddie Mac face no serious competition in the secondary-debt market. This critique is disproved by examination of the market share held by Fannie Mae and Freddie Mac, which is 12 percent and 8 percent respectively, compared to commercial banks, which hold 20 percent.

Two final theories have been forwarded that are critical of Fannie Mae's role in the secondary-debt market.  First, some have charged that Fannie Mae has deviated from its charter by entering new avenues of business. Fannie Mae almost exclusively manages residential debt, and does so through two lines of business, both of which expand liquidity, consistent with the charter. The final theory asserts that housing enterprises have a negligible effect on lowering interest rates for homeowners. Simple reflection of published rates clearly shows the benefits to homebuyers in the form of lowered costs for loans financed by Fannie Mae.

The role of Fannie Mae, per federal charter, is to provide low-cost mortgages to homebuyers. If it is the policy of the United States to support this end, as has been repeated by President Bush and the Republican Party, then Fannie Mae is doing precisely what it should: creating a nationwide market for the long-term, fixed-rate mortgage that can be refinanced any time without penalty, the loan choice for the vast majority of homeowners in the United States. Without Fannie Mae providing this service, lending to homebuyers would revert to banks, which are less likely to provide such loans and are more sensitive to short-term economic conditions.

AEI staff assistant Gordon Gray prepared this summary.

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