TCS Daily

Growth After Greenspan

By Richard Roll - October 25, 2005 12:00 AM

Federal Reserve Chairman Alan Greenspan will soon leave his post, with deserved applause. But he remains a man of mystery in many ways, particularly regarding his pronouncements on Fannie Mae and Freddie Mac.

Earlier this year, I was mystified by Chairman Greenspan's call for severe reductions in the home mortgage holdings of the two Government-Sponsored Enterprises (GSEs), created to support U.S. housing finance.

He mystified me even more in a recent letter to Sen. Robert F. Bennett, in which he again encouraged a swift, deep cut in the portfolios, while at the same time recognizing the vital role the two GSEs play in keeping the mortgage market afloat in times of market crises:

        "We ... believe that should there be a market crisis where secondary mortgage 
        market liquidity dries up, Fannie and Freddie, with their regulator's approval, should be 
        able to temporarily expand their portfolios by issuing debt and purchasing MBS 
        [mortgage backed securities]."

Greenspan previously had played up the risks of Fannie's and Freddie's portfolio purchases and dismissed their providing any service to home buyers or the economy. As late as May, he had told the Atlanta Fed that the GSEs' portfolio purchases "do not contribute usefully to mortgage market liquidity." He said then that the provision of liquidity to the market could be "accomplished exclusively through the securitization of mortgages" -- by their packaging mortgages into securities sold on the market.

It was that view that encouraged the Senate Banking, Housing & Urban Affairs Committee to pass legislation that essentially ordered cuts in the two mortgage market makers' portfolios.

Greenspan's recognition now that their portfolio purchases can serve an important purpose ought to give lawmakers pause as they consider action this week to reform their operations. For it basically reflects an important piece of history that Greenspan had ignored in previous testimony -- that the rapid GSE portfolio growth occurred primarily during financial crises and was vital in helping ease them.

When a global liquidity crisis nearly paralyzed world capital markets after Russia's default and a major hedge fund's near-insolvency, the U.S. housing finance system and American home borrowers -- alone among all U.S. fixed-income markets and borrowers -- were notably unaffected. Why? Fannie Mae grew its mortgage portfolio by 31 percent and Freddie Mac by 55 percent, responding directly to other investors' flight from the mortgage market. Such growth was unprecedented, but driven by market forces.

Fannie and Freddie's actions provided market liquidity -- a vital social benefit -- that other investors, lacking government sponsorship, could not provide. No wonder, then, that Greenspan has modified his stance on capping the portfolios to allow them to provide liquidity in similar situations in the future.

The issue now devolves in how they should unwind their portfolios after acquiring them -- rapidly, in fire sale fashion, or as market conditions and profit considerations suggest.

Jumping in and then rapidly pulling out doesn't make a lot of sense, considering that Freddie's and Fannie's mission is to provide a stable, liquid and affordable supply of home mortgage finance nationwide. They do that by creating a secondary market for home mortgages -- not by lending to consumer-borrowers, but by standing ready to buy mortgages from lenders at all times, thereby ensuring that lenders always have mortgage money to lend and that mortgages remain stable and liquid investments at all times.

Greenspan obliquely recognized the importance of this role in 2002, observing, "Especially important in the United States has been the flexibility and size of the secondary mortgage market. Since early 2000, this market has financed the large debt-financed extraction of home equity that, in turn, has been so critical in supporting consumer outlays in the United States throughout the recent period of cyclical stress." Simply put, GSE secondary market purchases drive rates down and increase credit availability, thereby conferring benefits on borrowers -- namely Americans buying homes or refinancing.

The fear Greenspan has had of the size of the GSEs' portfolios is overblown. Because they can't lend directly, the GSEs depend on the willingness of large banks to sell mortgages to them. In fact, while large bank mortgage portfolios grew very rapidly in 2004 under favorable conditions, neither Fannie Mae nor Freddie Mac's portfolios grew materially, increasing only 0.7 percent and 1.3 percent, respectively. Indeed, the GSEs' portfolios grow only as necessary to maintain a healthy and stable affordable housing market.

With growing concern about the residential real estate sector and the fear that some parts of the country will see a downturn in house prices, it would seem counterproductive to limit the ability of the GSEs to provide stability to the market. Indeed, Greenspan's arbitrary caps on the retained portfolios would take the GSEs out of the market just when they are needed. And even if a regulator was given flexibility to increase their caps in times of crisis, the admonition they sell quickly would increase mortgage market volatility, leading consumers ultimately to pay higher prices.

The GSEs, with portfolios unconstrained by arbitrary limitations, can fuel counter-cyclical and anti-recessionary expansion of consumer investment in housing and other durables, if needed, something Greenspan now recognizes as important. And with America's vibrant society forming 1.3 to 1.6 million new households each year -- requiring an added $1 trillion in new mortgage financing yearly over the next decade -- the nation will continue to need a fully functional Fannie Mae and Freddie Mac.

What's critical to the future strength of our nation's housing sector, and by extension our nation's economy, is that GSE reform be sensible. It should not stumble into the trap of artificially limiting Fannie Mae and Freddie Mac's growth. If Congress places limits on the growth of GSEs, it will constrain a source of liquidity and stability for the economy for the new Fed chairman that his predecessor has enjoyed through good times and bad.

Professor Richard Roll, a past president of the American Finance Association, holds the Japan Alumni Chair of Finance at the Anderson School of Management, University of California, Los Angeles.



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