September 2005
Will Portfolio Limitations for Fannie Mae and Freddie Mac Adversely Affect Residential Finance?
Committees in the U.S. Senate and House of Representatives have adopted bills that would modify the regulation of Fannie Mae and Freddie Mac, and both houses could act upon these bills in the fall. The most controversial element of the proposed legislation is a provision in the Senate committee bill (S. 190) that would reduce the size of the GSEs’ portfolios of mortgages and mortgage-backed securities. Fannie and Freddie contend that limiting or reducing their portfolios will adversely affect the residential mortgage markets, especially interest rates; others argue the change will have no adverse effect on interest rates and will reduce the risk the companies create for taxpayers and the economy in general. At a September 13 AEI panel discussion, experts discussed the potential effects of portfolio limitations as well as other issues surrounding the GSEs.
Peter J. Wallison
AEI
S. 190, a bill reported by the Senate Banking Committee in July, contains a provision that would prohibit the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac from acquiring a portfolio of mortgages other than for purposes of securitization. Although the GSEs argue that eliminating portfolios would lead to higher interest rates and have other adverse effects on the housing market, their arguments do not hold up.
Fannie and Freddie claim that their mortgage portfolios act as “shock absorbers” that promote stability in the housing market during times of crisis. However, September 2001--when the terrorist acts occurred--was the month in which Fannie purchased the least number of mortgages and made the fewest retained commitments to buy mortgages in the future. In addition, Fannie’s purchases as a percent of total business volume in September 2001 were the second smallest for that year.
Fannie and Freddie also argue that the portfolios are necessary to attract foreign investment into the U.S. residential finance market. Yet according to a Wall Street Journal article on August 24, foreign investors continue to buy mortgage-backed securities (MBS) in spite of the possible housing bubble. Were portfolios either limited or eliminated, Fannie or Freddie could continue their business through securitization, thereby reducing the threat of systemic risk, and still maintain a steady stream of foreign investment.
Finally, recent trends in Fannie’s and Freddie’s senior and subordinated debt demonstrate the further need for Congress to eliminate the GSEs’ portfolios. Despite Fannie’s admission that it cannot publish any financial statements until 2006, the spread of its debt securities over treasuries is declining. Clearly, the market perceives Fannie’s debt as government-backed. The only way to obviate a future taxpayer bailout of the GSEs is to eliminate the portfolios, thereby sharply reducing interest rate risk and sparing the economy from systemic risk.
Jim Grant
Grant’s Interest Rate Observer
It is impossible to predict whether interest rates would rise or fall as a result of reducing Fannie’s and Freddie’s portfolios. To demonstrate how one cannot accurately forecast interest rates, Mr. Grant posed a thought-experiment to the audience. Suppose that the Consumer Price Index (CPI) was rising by 4 percent a year. How high could long-term treasury yields realistically rise? An audience member responded, “7 percent.” However, in the spring of 1984, the CPI was rising at about 4 percent, but the thirty-year government bonds were trading close to 14 percent.
To further demonstrate the point, Mr. Grant asked the audience to suppose that the Federal Reserve had been pushing up money-market interest rates steadily over the course of a year and three months by 2.5 percentage points. Should long-term bond yields rise or fall? Although most of the audience murmured, “fall,” this has not been the case. Since the spring of 2004, the Fed has undertaken this very policy, and yields have actually risen.
To conclude, there is no “if this, then that” in interest rate prophecy. Therefore, one cannot accurately predict what will happen to interest rates if Fannie and Freddie lose their portfolios.
Robert Lacoursière
Banc of America Securities
Mr. Lacoursière has issued a sell rating for Fannie Mae and a neutral rating for Freddie Mac. His negative view of investing in the equity of the two GSEs stems from the fact that Fannie’s and Freddie’s retained portfolios are of utmost importance in the valuation of their equity.
Between 1992 and 2004, the average return on equity for both Fannie and Freddie was about 30 percent--double that which is found in the rest of the mortgage insurance business. From this statistic, Lacoursière reached several conclusions. First, the equity of Fannie and Freddie is very profitable. Second, it has almost unlimited growth potential. In fact, Fannie and Freddie were able to grow beyond the bounds of the underlying mortgage business. Third, Lacoursière found that the portfolios mitigated the risk of the underlying insurance business. Over time, Fannie and Freddie added to their portfolios when the greatest spreads between debt and yield were available. This went on when the underlying credit cycle was negative. Thus, Fannie and Freddie were becoming more profitable, growing faster, and were less risky.
Clearly, without the portfolios, Fannie and Freddie would not be worth as much as they are today. However, they could still carry out their underlying housing mission without the retained portfolios. They could securitize the mortgages, and if the market believed that the securities were government backed, that would result in a subsidy for borrowers wanting to buy houses through mortgages. In the long run, portfolios will shrink, the market will recognize the risk of the equities, and the GSEs will grow slower and be worth less.
Jason Thomas
Senate Republican Policy Committee
GSE reform is not a partisan issue. Five years ago last March, President Clinton’s undersecretary of the treasury, Gary Gensler, testified to the administration’s position on reducing the systemic risk posed by Fannie Mae and Freddie Mac. Mr. Gensler advocated repealing the GSEs’ provisional line of credit with the Treasury, repealing the exemption that allows banks to hold an unlimited amount of GSE securities, installing a new regulator with the authority to set minimum and risk-based capital standards, and appointing a receiver to resolve a distressed GSE. He also stressed that the GSEs need to focus their activities precisely on their mission and limit their non-mission investments.
Another Clinton administration official, former assistant secretary Rick Carnell, spoke about the GSEs’ “double game,” whereby they seek to convince financial markets that their obligations are backed by the U.S. Treasury, while simultaneously arguing to Congress that they receive no subsidy and receive less federal support than depository institutions. Throughout the course of this double game, Fannie and Freddie successfully deflected most criticism. Also, many viewed critics of the GSEs as unnecessarily risk averse and as holding an anti-housing bias.
However, this all changed as a result of Fannie and Freddie’s failure to implement FAS 133. In addition to revealing Fannie and Freddie’s internal control failures, the situation aroused a great deal of interest and provoked tough questions about the GSEs’ operations. For instance, if no federal guarantee on GSE debt exists, how does one explain the fact that the yield spread on Freddie’s subordinated debt barely budged, and has since declined, despite its internal problems and inability to produce audited financial information?
The Treasury, Federal Reserve Board of Governors, and the Senate Banking Committee have advocated that the GSEs securitize their mortgages. In doing so, all the potential benefits the GSEs provide would remain, yet systemic risk would be nearly eliminated. Although Fannie and Freddie will be reluctant to sacrifice their portfolios, which account for 65 to 85 percent of their profits, shareholders will not be as bad off as the GSEs expect. For instance, Fannie and Freddie will no longer carry political risk. In addition, the GSEs will still have legal ownership of the mortgages they purchase, so they will still be able to decide the most profitable way to structure cash flows.
Moreover, there is a strong market for MBS, especially overseas. Because MBS are of AAA credit quality, represent a market nearly as deep as the Treasury market (just under $4 trillion), and are highly liquid with an average daily trading volume of nearly $250 billion, they are ideal investments for (Asian) central banks in need of dollar-denominated assets.
Lawrence J. White
New York University
Fannie and Freddie have two primary businesses: (1) they issue MBS—essentially guaranteeing the credit risk of mortgages—and charge about a 20 basis point (bps) fee for this service, and (2) invest in portfolios of residential mortgages, 97 percent of which is funded by debt. They are publicly traded companies, but have congressionally legislated charters. The president can appoint five of their eighteen board members, they pay no state or local income taxes, and they each have a potential line of credit with the treasury of up to $2.25 billion. Their securities are “government securities” under the Securities Exchange Act of 1934 and can be purchased in unlimited quantities by banks and thrifts, and the Federal Reserve can purchase them for open-market operations. Fannie and Freddie are not required to register their securities with the SEC, they are exempt from SEC fees, and they can use the Fed as their fiscal agent. Further, there is no insolvency resolution process available to the Office of Federal Housing Enterprise Oversight (OFHEO). Bankruptcy laws do not apply to Fannie and Freddie, and only Congress can appoint a receivership.
However, the GSEs do face limits. They cannot go outside of residential mortgage finance, originate mortgages, or buy mortgages over a certain value ($359,650 in 2005). Also, they are subject to mission regulation by the Department of Housing and Urban Development (HUD), as well as safety-and-soundness regulation by OFHEO.
As a result of these institutional arrangements, the financial markets treat their obligations as special “agency” debt. This enables Fannie and Freddie to borrow at about 40 bps lower than their financial position would otherwise permit. Because they can borrow at a cheaper rate--in addition to saving on taxes and fees--the GSEs end up reducing mortgage interest rates by approximately 25 bps. However, because housing is already subsidized, cheaper mortgage rates are not necessarily good. These cheaper rates do not necessarily benefit people who truly need it; rather, they can go to people remodeling their residences. A direct subsidy to people of lower incomes or first-time buyers would likely be more effective at meeting Fannie and Freddie’s central mission of expanding homeownership. Moreover, because of the agency status, we cannot be sure if they are truly efficient and good at what they do. Plus, since the financial markets believe that their securities have an implicit federal guarantee, taxpayers may be at risk.
Between 1990 and 2004, Fannie and Freddie experienced enormous gains in the aggregate value of their mortgage portfolios and their MBS. In terms of mortgages in portfolio, Fannie and Freddie’s volume grew from $56 billion to $905 billion and $5 billion to $664 billion respectively. For MBS over those fourteen years, Fannie went from $0 to $1,403 billion, and Freddie from $17 billion to $852 billion.
The portfolios are quite large and embody credit risk and interest-rate risk. While few people are concerned with the credit risk, no one knows how well the GSEs are hedged against interest-rate risk. Because of the implicit government guarantee, the financial markets do not monitor the portfolio adequately. OFHEO’s safety-and-soundness regulation was supposed to take the place of private monitoring, but this has turned out to be inadequate. If safety-and-soundness efforts falter, there could be systemic effects. Fannie and Freddie are large and if one were to fail, there could be a “contagion” situation.
Even with portfolio limits, the MBS business could continue as before. For instance, in 1990, Freddie had $316 billion in MBS compared to $5 billion in pure mortgages. Were the GSEs to securitize their mortgages, there would tend to be asset substitution. Depositories--banks and thrifts--would likely expand their holdings of mortgage assets. These institutions would in turn carry the interest-rate risk. This would be a positive development, as the risk would be spread out. Plus, banks and thrifts are regulated by several agencies that understand interest-rate risk well. Incidentally, mortgage interest rates would likely rise by perhaps as many as 10 bps relative to baseline levels, though given the extent to which housing is already subsidized, this would not necessarily be a turn for the worse. Ultimately, however, the best way to deal with the GSEs is to fully privatize them and create new government programs that are specifically focused on increasing homeownership for people with lower incomes and first-time buyers.
AEI staff assistant Dan Geary prepared this summary.
