TCS Daily

'Be Careful What You Wish For'

By Duane D. Freese - April 8, 2005 12:00 AM

Do Freddie Mac and Fannie Mae, the government created secondary mortgage market makers, pose a threat to the nation's financial system or a safety valve for the economy?

That's a question for lawmakers as they assess the testimony this week and next from Alan Greenspan and others on the two government sponsored enterprises (GSEs); it's one they need to answer before racing ahead with reforming them.

The two agencies have been instrumental in making America's favored vehicle for home buying -- the 30-year, low down payment, fixed-rate prepayable mortgage -- more affordable to more Americans. They do that by not directly lending to the public -- they can't do that by law -- but by bundling up mortgages of up to $330,000 sold by others and selling them on the international market, creating a secondary mortgage market plus issuing debt to lenders in order to buy mortgages for their own portfolios.

No one has a problem with them buying and bundling mortgages for sale. But many have become concerned about them issuing debt to buy mortgages for their own portfolio, which has grown to $1.5 trillion. The critics see that activity as simply making money for GSE shareholders rather than a support for mortgage lending. In addition, they argue such activity poses large risks for the financial system in the event that Fannie and Freddie are caught short in paying for the debt they buy if their portfolio mortgages lose value.

At Senate Banking Committee hearings Wednesday on regulation of the GSEs, Federal Reserve Chairman Alan Greenspan was among those sounding alarms:

        "We at the Federal Reserve remain concerned about the growth and 
        magnitude of the mortgage portfolios of the Government Sponsored 
        Enterprises (GSEs), which concentrate interest rate risk and prepayment 
        risk at these two institutions and makes our financial system dependent 
        on their ability to manage these risks...To fend off possible future systemic 
        difficulties, which we assess as likely if GSE expansion continues unabated, 
        preventive actions are required sooner rather than later."

Later, he went on:

        "World-class regulation, by itself, may not be sufficient and indeed might 
        even worsen the potential for systemic risk if market participants inferred 
        from such regulation that the government would be more likely to back GSE 
        debt in the event of financial stress. This is the heart of a dilemma 
        in designing regulation for GSEs."

It all sounds so sensible. But the Fed chairman was dismissive in his testimony of the GSEs' contribution to easing the nation through recent financial and economic turmoil, such as the 1998 Russian debt crisis and the crisis following 9/11. And on those points the eminent Fed chairman may simply be wrong.

Economic analysts at Greenwich Capital Markets who have studied those issues, countered Greenspan's testimony:

        "We argue that the agencies (Freddie Mac and Fannie Mae) provide an 
        important backstop that has been demonstrated in the past and this increases 
        the liquidity and depth of the agency mortgage market."

The GCM analysts raised concerns about limiting the portfolio purchases of Fannie and Freddie "because it is difficult to predict the extent of support needed prior to a crisis."

Akash Deep, an economist at Harvard University, and Dietrich Domanski of the Bank of International Settlements came to a similar conclusion, noting in a 2002 study in BIS Quarterly Review that a "strong expansion of the GSEs' retained mortgage portfolios seems to have played an important role in absorbing increasing mortgage origination and refinancing."

That refinancing, the two economists noted, "appears to have supported household spending. At least in the United States in 2001, this seemingly had a significant countercyclical effect."

As the Harvard Joint Center on Housing has noted in its State of the Nation's Housing in 2004, home prices have enjoyed a prolonged appreciation without the kinds of sharp rises and falls that occurred during past recessions and financial crises. That reinforces the view that Fannie's and Freddie's activities well may have contained both financial and economic contagion.

But have they in the process created even greater risks either for taxpayers, as occurred in the S&L troubles of the late 1980s and early 1990s, or for the economy down the road? That's the purported reason Greenspan wants their portfolio purchases curtailed.

Even there, though, he may be focusing too much on the size of the two GSEs portfolio -- at $1.5 trillion -- and not at the actual risk posed by Freddie and Fannie holding it.

James C. Miller III, former head of the Office of Management and Budget and chairman of the Federal Trade Commission, undertook his own study of Freddie Mac and told me he found it "much more sound and resistant to financial threat than other institutions."

Economists for Credit Suisse Equity Research First Boston noted in the October Global Investor Digest that a pull-back by GSEs in their portfolio purchases is being filled by small and mid-cap banks. And that may not be a good thing.

While critics of GSEs say that the appearance of government support for them gives them both an interest rate break in the market over competitors and encourages bad investment decisions, the banks buying the mortgages have explicit government support with deposit insurance. But they have no capital standards for the interest rate risk as the GSEs do. And they also lack the GSEs' sophistication in distributing that risk to others. So, those who propose limits on GSEs believing they will reduce risk could increase it instead.

As the CSER economists concluded: "[I]n contrast to the GSEs, the thrift banks fly naked in the face of interest rate risk. The thrifts could well flourish for a while but students of history will know how this ends. So be careful what you wish for."

Indeed, conservatives have often said that in economics it's the unintended consequences you need to look out for. Those seeking to reform the GSEs need to look at what their actions would do from all angles. For even Alan Greenspan can be wrong sometimes.


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