TCS Daily

Regulation is not Enough for Fannie and Freddie

By Desmond Lachman - March 5, 2004 12:00 AM

Last week, in commendable acts of public candor, Alan Greenspan, the Federal Reserve Chairman, and Gregory Mankiw, the Chairman of the Council of Economic Advisors, sounded the alarm about the risks that Fannie Mae and Freddie Mac pose to the US financial system. By so doing, they reminded us of the gargantuan risk to which these enterprises now expose the US taxpayer. However, the solution of improved regulation that Messrs. Greenspan and Mankiw propose for Fannie and Freddie falls woefully short of what is really needed to protect the US taxpayer from future large claims on the budget.

Messrs. Greenspan and Mankiw are rightly uneasy about the scale and the growth of the mortgage-related asset portfolios held on Fannie and Freddie's balance sheets. Indeed, they have to be concerned by the fact that over the past ten years, the outstanding debt of these enterprises has increased more than sevenfold, from a total of around US$200 billion in 1992 to around US$1,500 billion at present. To put this expansion in context, Fannie and Freddie's combined debt is now equal to a staggering 39 percent of the total US public debt outstanding. Meanwhile, the combined financial assets of Fannie and Freddie are now worth around 45 percent more than that of Citibank, the largest commercial bank in the world. Unlike Citibank, which has a very highly diversified balance sheet, Fannie and Freddie are almost exclusively exposed to interest rate and housing related risks.

The dramatic growth in Fannie and Freddie's balance sheets in recent years has been facilitated by the perceived special advantage that these enterprises enjoy as a result of numerous state privileges and preferences. This allows them to borrow in the markets at significantly lower rates than their potential private sector competitors. Thus, despite the explicit statement on the prospectuses of these enterprises' debentures that the US government does not back them, most investors have concluded that during a crisis the government will prevent these enterprises from defaulting. As a result, Fannie and Freddie can borrow at subsidized rates, which has allowed them to pay higher prices to originators for their mortgages than can potential competitors. This advantage has enabled them to gradually but inexorably take over the market for conforming mortgages.

Of equal concern to Messrs. Greenspan and Mankiw must be the fact that both Fannie Mae and Freddie Mac have moved increasingly into the risky mortgage-investment business in an effort to boost their profitability. Thus, whereas in 1992, Fannie and Freddie retained about 2 percent of the Mortgage Backed Securities that they issued, by 2001 they retained 33 percent of those securities. As a result, these two institutions between them now have investment holdings totaling around US$1400 billion, which makes them highly vulnerable to interest rate movements. Such vulnerability is all the more worrying since Fannie and Freddie currently operate with leverage ratios of more than 40-to-1, which is more than twice that of the better regulated banks and savings and loan institutions.

While it is true that mortgage assets -- the principal constituents of Fannie and Freddie's portfolios -- present less credit risk than other kinds of assets, they present far more interest rate risk. This is in part because mortgagors have the option of refinancing their mortgages when interest rates decline, but they can continue to hold their mortgages at a predetermined fixed rate when interest rates rise. Interest rate risk also derives from the fact that Fannie and Freddie tend to borrow at shorter durations than they lend, which exposes them to the risk of sharp spikes in interest rates. The danger of interest rate volatility in the period immediately ahead is underlined by the widening in the government's budget deficit as well as by the rather gloomy outlook for the US dollar under the weight of a historically high external current account deficit.

While hedging interest rate risk by Fannie and Freddie could minimize the risks of interest rate volatility, the own experience of these enterprises suggests that such hedging is far from infallible. Moreover, given the very size of their balance sheets, there must now be questions as to whether markets are deep enough to afford these enterprises with the necessary hedging and whether substantial counterparty risk does not exist.

Alan Greenspan is certainly aware of the huge interest rate risk to which Fannie and Freddie expose the US taxpayer. Yet the regulatory changes that he is proposing to Congress are timid in relation to the problem that they seek to address. Indeed, the main thrust of Mr. Greenspan's recent recommendation is that Congress create a regulator for Fannie and Freddie on a par with that of banking regulators with a free hand to set appropriate capital standards for these enterprises. Additionally he is arguing in favor of limiting the amount of new debt that these enterprises might issue. However, he is not requiring that they either reduce the size or change the composition of their balance sheets.

If one is really serious about reducing the interest rate risk to which these enterprises expose the taxpayer, should one not be thinking of more radical solutions to the Fannie and Freddie problem? Might one not think for example of introducing legislation that would forbid these enterprises from purchasing whole mortgages and mortgage-backed securities, which is the real source of their interest rate exposure? This would enable Fannie and Freddie still to provide liquidity to the housing market by creating pools of mortgages and selling them to investors without taking on undue interest rate risk. Or might one not go further, as proposed by my colleague Peter Wallison, and think of both completely privatizing these enterprises and breaking them up into five or six competitive companies? This would reduce the risk that the government would have to ride to the rescue of these enterprises in the event of their bankruptcy on the grounds that they were too big to fail.

Limiting oneself to regulatory reform of Fannie and Freddie along the lines suggested by Mr. Greenspan hardly reduces the risk of repeating the savings and loan type crisis of the 1980s. That would be a great and unnecessary pity for the American taxpayer. It would also show how little we have learnt from the 1980s crisis in the savings and loan industry, which after all was also supposedly well regulated.

The author is Resident Fellow at the American Enterprise Institute.


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