TCS Daily

Nothing Trumps Some Things

By Duane D. Freese - January 17, 2006 12:00 AM

Sometimes doing nothing has its own rewards.

At the end of 2005, the Office of Federal Housing Enterprise Oversight (OFHEO) announced that Fannie Mae and Freddie Mac, the two government sponsored enterprises (GSEs) responsible for maintaining a national mortgage market, exceeded their capital requirements -- Fannie at $37 billion by $752 million; Freddie, at $36.3 billion, by a whopping $4.7 billion.

The finding is significant because the two mortgage giants' capital requirements were increased by 30% after accounting errors were disclosed in 2003, errors that led to the forced resignation of their top executives and required a restatement of earnings, about $11 billion downward for Fannie and $5 billion upward for Freddie.

And these gains in financial safety were made without Congress enacting the Draconian reforms critics in the White House, Federal Reserve, Congress and some think tanks were demanding last year.

The accounting irregularities bolstered critics' claims that a portion of the GSEs business -- their buying of mortgages financed through the issuing of bonds -- might pose a systemic risk to the financial system if left unchecked.

Some, including Fed Chairman Alan Greenspan, called for reducing the two GSEs' portfolios from $1.5 trillion to about $200 billion. That minimum amount would be required for them to carry out the other part of their mortgage market making purpose, the buying and bundling of mortgages together to sell directly to investors, for which they receive a fee.

The portfolio reform really never made much sense, except for those who wanted to push for full privatization of the GSEs or to certain national banks that would gain an advantage over regional competitors by limitations on GSE mortgage activities.

But at what cost? Homebuyers here have one product available to them home buyers elsewhere don't -- the 30-year, fixed-rate, prepayble mortgage. That is one major reason homeowning is so affordable here, and why homeownership rates here are the envy of the rest of the world. Making that possible has been the GSEs making a national mortgage market available, both through their securitization of mortgages and, during times of liquidity crunch, the buying of mortgages for their own portfolios.

The most curious thing about the reform effort, though, is that the accounting irregularities had nothing to do with the mortgage portfolios, which the critics targeted.

This truth about the GSEs and their critics was laid bare in a speech to the Bond Market Association in Hong Kong by Stephen A. Blumenthal, acting director of the OFHEO, which oversees the two GSEs.

The speech is remarkable in two senses. Blumenthal was responsible for helping uncover problems at Freddie Mac, so he is intimately aware of its problems. More importantly, by rubbing against the White House and Treasury positions on the GSEs, Blumenthal assured himself that he would not be made permanent director of OFHEO or any subsequent agency.

Thus what he had to say was both knowledgeable and without self-interest. And what he said was this:

  • Freddie's and Fannie's financial problems had nothing to do with faulty risk management of their mortgage portfolios, as some critics had intimated, but accounting and management impropriety.
  • Fannie and Freddie portfolios aren't without risk, but "their credit risk management has been exceptional and their actual experience with interest rate risk should satisfy even the most critical."
  • Concerns about the risks Fannie and Freddie pose to the economy "are concerns about 'potential' impacts and not based on actual experience."

That last point makes great sense when you look at the actual figures. The GSEs' portfolios account for only 18% of the mortgage market. Banks hold 46% of the $9.2 billion in residential mortgages outstanding, with life insurance companies, foreign investors, pension funds and individuals holding the rest.

Thus, if you are talking about systemic risk from mortgage portfolios, for all that Congress may do to increase regulatory authority over the two GSEs, managing the risk will require a "collective effort of GSE and financial service regulators as well as other participants in the financial system."

The notion that the risk would go away if only the GSEs get rid of their portfolios is laughable. It only spreads the risk around more, from those with exceptional skills in managing it to, perhaps, those with less adequate skills. And as University of Florida finance scholar Mark Flannery, co-author of Flannery & Flood's ProBanker financial game and editor of Money, Credit and Banking, noted in a mid-year presentation at the American Enterprise Institute, that makes as much sense as giving everybody a bit of nuclear waste to keep in their basement rather than concentrating it in a place and in the hands of people who could deal with it safely.

Only in this case, both homeowners and investors would suffer the fall out.

"You reduce the profitability of these companies (as reducing their portfolios would do) and you've just caused a massive sell-off of the equity in these companies," Blumenthal noted in response to a question after his speech. "That would really be sort of a trick played on shareholders. ... That is a fact and considering the massive holdings of Fannie Mae and Freddie Mac stock by mutual funds and pension funds, it is something the policymakers should take into consideration in crafting legislation."

As for homeowners, if investors decide not to put as much money into mortgages, what good will come for them from that? Higher interest rates and more difficulty selling homes, perhaps?

So, the good news of the last year is that the Congress did nothing and the GSEs appear to have put their financial house in order. More good news this year is that while the White House and others are still talking about GSE reform, they are talking about improving oversight and not pointing at their portfolios.

The less Congress and the administration do, the better off homebuyers will be.


GSE- goverment sponsored Enron
I've read that argument before that not having the
GSE's retained portfolios puts the problem in other
peoples hands, people that aren't experts like the
GSE's so it must be worse.

The problem with that argument is that the usual way
puts the risk in the hands of the private businesses
that are accepting the risk to make a profit. With
the retained portfolios, GSE's are concentrating risk
in the hands of the public for the benefit of private
profit of the shareholders and officers of the

The other argument is that if the GSE's stop
artifically supressing the cost of borrowing,
everybodies house will go down in price. If you
accept that, then you are in fact also saying the
putting the GSE's in place made the price of housing
go up- so how does that make housing more affordable?

In fact the whole pitch of the GSEs is that they make
the cost of borrowing cheaper, but this in practice
doesn't make housing cheaper, because people just bid
the price up to take into account the lower cost of
borrowing. So while the interest rates may be lower
than they should have been, the balances are higher.

I do agree that these kinds of policies make home
ownership rates higher- they create a spending
preference where there may not have been one- call it
social engineering by tax policy. I don't know if
ownership inherently "good". Arguments can be made
either way. But I do know that manipulation of
peoples life choices by way of goverment policy is

I agree with you that congress and the Whitehouse
should keep there hands out of the real estate lending
market, and thats why the GSE's should be cut loose to
compete the same as any other private institution.

This period of historiclly low interest rates is
largely a result of the retained portfolios. This
large holding represent an absorbtion of risk by the
US tax payer, and this allows purchasers of this debt
to commend a lower risk premium.

The Austrian school of business cycles says that its
the intervation of the government into the market
(through credit expansion) that causes the boom and
bust that neccessarily follows. The occlusion of the
normal market signals causes "malinvestment". So
perhaps doing nothing is the best thing; when the bust
comes, they can find all the cheerleaders of the GSEs.

Ownership and responsibility trumps all.
The government can easily eliminate this issue by forcing the GSEs off of being government backed into being backed by their owners. Then the GSEs could be a trillion underfunded or overfunded and it will be up to the risk takers, owners, to do something about it.

Instead we need an act of congress to make sure these entities created by congress are not stealing money.

implied versus direct government obligations
Sure, privatize the GSE's but don't stop there.
While the GSE's have the "implied" guarantee of the US govy in case of crisis or default, the Government chartered banks and the FHA/VA are directly backed by the Govy. So why the expansion of FHA credit risk parameters and increased loan limits to "be more competitive"? Why even consider increasing the FDIC bank insurance amounts? Trading "implied" guarantees of the GSE's for direct obligations of the Federal government is a loser for the taxpayer. Let's address these direct obligations as we unwind the GSE's.

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