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| Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac May 1996 |
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The housing government-sponsored enterprises claim that, consistent with their charters, they provide four general types of public benefits.(1) Those benefits are:
To evaluate those claims, one must apply several criteria, including:
Providing Lower Interest Rates to Home Buyers
The unbooked and unbudgeted subsidies that the government provides to the housing GSEs pay the lower interest rates that the GSEs deliver to home buyers. Those lower interest rates are rebranded with the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation logo before they reach the home buyer, but that does not change the role of taxpayers as the source of those benefits. Fannie Mae and Freddie Mac are just one of several delivery vehicles that the Congress could use to make that transfer to home buyers. In fact, using GSEs for that purpose fails the money's worth and sustainability tests.
Using a duopoly to provide a subsidy to home buyers does not give good value for the money. Without vigorous competition, the intermediaries retain a significant portion of the subsidy rather than passing it through. If the subsidy was offered to all conduits willing to accept the restrictions that accompany those privileges, the housing GSEs would be forced to pass through the entire subsidy either to meet the competitive price for mortgages or to forestall entry by competitors. Through a competitive delivery system, the government could provide the current benefit and save the retained subsidy. Establishing a competitive secondary market for conventional conforming mortgages would also ensure that any realized profits were earned, not bestowed by government policy.
The current system also raises a significant sustainability issue. Fannie
Mae and Freddie Mac have the impossible task of deciding to which group
they are more responsible: their shareholders or home buyers (the intended
beneficiaries of the subsidy).
Providing Market Stability
By integrating local mortgage markets with organized capital markets, the housing GSEs added stability to local mortgage lending. When the GSEs were established, that benefit may have been worth paying for.
Today, circumstances are vastly different. Securitizing mortgages is now "a routine financial transaction."(2) Numerous firms have mastered the technology of securitizing mortgages and are searching for profitable opportunities to apply that technology. Private conduits have replicated the integrating services of Fannie Mae and Freddie Mac. The supply of mortgage financing to local housing markets no longer depends on subsidizing the housing GSEs. Those GSEs accelerated the use of the technology for securing mortgages to integrate mortgage and capital markets, but the continuing cost of federal sponsorship is difficult to justify today for a benefit that others are willing to provide without a subsidy.
Recently, however, Fannie Mae set out a view of its role in stabilizing markets that extends beyond what might be expected of a fully private mortgage dealer and intermediary. Specifically, Fannie Mae argued that:
Providing liquidity to the residential mortgage market is at the core of Fannie Mae's and Freddie Mac's activities. . . . The special mission of Fannie Mae and Freddie Mac requires them to be in all markets at all times. Fully private firms have no such obligation. That explains the very different responses to regional downturns. When, for example, the oil prices fell, turning boom into bust throughout the "oil patch" states, many private firms cut back on (or eliminated) their mortgage lending in those states. By contrast, Fannie Mae remained an active buyer of both new and seasoned home mortgages. As a result, Fannie Mae's purchases relative to total loan origination in Texas almost doubled. . . . Besides swapping loans for MBS [mortgage-backed securities], mortgage lenders even in regions facing economic difficulties can sell mortgages to Fannie Mae and Freddie Mac for cash at the same posted prices as lenders everywhere else.(3)
On its face, that statement seems inconsistent with the stabilization role that could be expected of a private intermediary and also with Fannie Mae's fiduciary responsibility to its market shareholders. To make that inconsistency clear, consider the contribution to stabilizing the market that fully private dealers provide.
Private Dealers and Market Stability
A dealer who stands ready to buy mortgages and sell mortgage-backed securities enhances market stability by assuring others of the opportunity to buy or to sell at quoted prices. Fully private dealers maintain almost all financial markets, including the most liquid of them all--the market for U.S. Treasury securities. To maintain a continuous market in any asset, a private dealer must have access to the flow of funds available in the organized financial markets. Such access is routinely available to highly capitalized intermediaries, except during periods of financial crisis--a phenomenon discussed below.
Private dealers attempt to profit from buying at all times, but they do so at prices that are a little lower than the prices they expect to receive when they sell. When buying, dealers prosper or fail on the basis of their ability to anticipate the price at which they will be able to sell. The risk of their business is that sales prices will be lower than were expected when purchases were made. Falling market prices usually cause dealers to reduce the prices they offer because they anticipate lower sale prices. Thus, dealers can provide a stable opportunity for sellers to sell when prices are falling, but they cannot offer to buy today at yesterday's prices after the market price has fallen. To put that more precisely, private firms may make a decision to incur losses on some activities and transactions but only in the expectation that such an action will have long-term benefits.
Fannie Mae's View of Stabilization
Fannie Mae's description of its behavior in the "oil-patch" recession differs from that of a fully private dealer in that the government-sponsored enterprise claims a willingness to purchase mortgages at unchanged posted prices even as mortgage values decline. The fall in oil prices and the accompanying recession in oil-producing states described by Fannie Mae prompted a rise in unemployment and a decline in wealth, income, and housing prices. All of those factors indicate an increasing credit risk on home mortgages secured by properties in the affected region. A lower quality of credit means higher expected losses from default and lower mortgage values. Faced with such a market change, private dealers must offer a commensurately lower purchase price if they are to recoup the purchase price when they sell. Ideally, dealers lower the prices they offer in those circumstances by just enough so that at the new price they can recover the increased default costs.
Fannie Mae claims that its unique role in stabilization forced it to ignore those higher credit risks and lower mortgage values and to pay the same posted prices for oil-patch mortgages as for less risky mortgages originated elsewhere. If so, Fannie Mae must have expected to incur losses on those purchases. That pricing decision also means that no other purchaser, including Freddie Mac, could buy oil-patch mortgages at Fannie Mae's prices without also expecting to lose shareholders' money. That pricing policy of Fannie Mae may explain why others "eliminated" lending in those states and why Fannie Mae obtained a larger market share.
Buying mortgages at above-market prices constitutes a transfer of shareholder wealth to mortgage sellers. It naturally raises questions about the limits--if any--on the amounts the GSE is prepared to transfer in such circumstances and about the amount actually lost in the cited case. Of course, one mitigating factor not discussed in Fannie Mae's statement is the contribution of private mortgage insurers (PMIs) to the stabilization role. Fannie Mae can satisfy itself that it has stood ready to buy all mortgages from all regions at all times, conditional on those mortgages meeting its quality requirements--including private mortgage insurance on loans with loan-to-property-value ratios above 80 percent. By raising the requirements for mortgage insurance on more risky loans, Fannie Mae can indeed stay in all markets at all times at unchanged prices, but it will have reduced the volume of qualified supply and lowered the net (after-insurance premium) benefit to the home buyer. Moreover, the price Fannie Mae actually pays for most mortgages is not necessarily the posted price but rather a negotiated price. The claim of being a reliable market maker lacks substance if the posted offer to buy is at a below-market price.
Assigning public benefits to the expanded stabilization role claimed by Fannie Mae involves a real dilemma: either the role is not substantively different from that performed by a fully private intermediary, or it entails a decision to transfer the assets and wealth of shareholders to sellers when the market value of mortgages is falling. The latter interpretation requires Fannie Mae's management to make decisions about distribution that are usually reserved for elected officials. That interpretation also raises the possibility that Fannie Mae's efforts at stabilization could conflict with the policy objective that the GSE operate in a manner consistent with its own financial safety and soundness.
Freddie Mac's View of Stabilization
Freddie Mac's interpretation of its stabilization mission appears to differ from that of Fannie Mae. In particular, rather than stress its willingness to purchase at a posted price "in all markets at all times," Freddie Mac has said:
Because we are the stewards of our owners' capital, we deploy capital only where the returns justify it. This focus provides a clear framework for making business decisions and drives the terms on which we will compete to purchase mortgages. It ensures that we will not pursue short-term growth, market share or earnings at the cost of unacceptable long-term returns on capital.(4)
Discussing recent performance, Freddie Mac's management noted in the same report:
Competition for [a] shrinking [volume of] origination caused a slackening of credit and pricing standards in the primary market. Against this backdrop, we continued to maintain our discipline. Although this may have occasionally reduced our business volume, this disciplined approach is consistent with our commitment to building shareholder value and putting families into homes they can afford to keep.
That interpretation of stabilization is consistent with that of a fully private dealer's contribution to promoting market stability.
Financial Shocks and Market Stability
On occasion, the financial markets of the world are subjected to shocks from such events as sharp declines in U.S. or foreign stock prices or the unexpected failure of a large financial institution. Such a shock can trigger a financial crisis or "panic," as they were called in the 19th century. During such a crisis, the capital markets may cease to function as reservoirs of funds. Financial market makers can be cut off from the funds they need to maintain stability. Markets may collapse as a result. Fortunately, the Federal Reserve and other nations' central banks are extremely sensitive to that danger and well equipped to counter those threats by providing liquidity to financial institutions, including market makers. Indeed, the Federal Reserve has been remarkably successful in doing so for the past 50 years.
The central bank is responsible for ensuring the stability of the national
financial markets. Fannie Mae and fully private intermediaries transmit
that stability to markets in which loans are originated by serving as conduits
to the national capital markets. So long as central banks effectively carry
out their mission, all conduits--both private and sponsored--can perform
the valuable service of making an integrated market in mortgages for the
entire country.
Advancing Technology
Fannie Mae and Freddie Mac claim to provide a significant national benefit as innovative leaders of the mortgage finance industry. One of the forms that leadership takes is the investment that the housing GSEs are making in automated underwriting systems. Those systems are intended to shorten the time required to get a mortgage approved by the lender, increase the ability of originators to identify good credit risks using nontraditional loan standards, and reduce the cost of mortgage origination. The GSEs have invested substantial amounts in that and related software development. If the software achieves their expectations, the nation will receive a benefit from such innovation. But like all innovations, this one has a cost: the investments that had to be given up because this particular innovation was undertaken. Investments in innovation have a net benefit to the country only if the benefits from the financed activity are greater than those that would have been realized from other uses of invested funds.
The market cost of capital disciplines the investment undertaken by
fully private firms. That is, no fully private firm would undertake an
investment for which the expected return was not at least as great as the
cost of funding the project. An investment hurdle equal to the market cost
of capital is socially useful because that market price is the expected
return on alternative investments. With GSEs, the subsidy by taxpayers
reduces the cost of capital below the market rate. Thus, GSEs can profitably
undertake investments for which the rate of return is less than the return
on investments that fully private firms undertake. Consequently, when the
GSEs invest in innovative technology, that decision is less likely to be
consistent with economic efficiency than if a fully private company made
the decision. Therefore, the claim that public benefits result from increased
investment in mortgage technology may fail the money's worth test.
Extending Low-Income Home Ownership
The Housing and Community Development Act of 1992 gave the Secretary of Housing and Urban Development authority to establish goals for the housing GSEs that were intended to increase access to mortgage financing for lower-income borrowers. For 1995, the targets set by the Secretary included:
Both GSEs exceeded their income-based targets by a considerable margin, but Fannie Mae barely reached the central-city target (at 30.4 percent) and Freddie Mac fell short (with 23.4 percent). Despite the existence of those goals, most observers agree that the "proportion of mortgages purchased through low-income home ownership programs is low relative to overall GSE conventional activity" and that GSE activity for rental housing is "small" compared with the "size of the market for multifamily lending."(5)
For 1996, the goal of the central cities has been redefined as a "geographically targeted" goal including rural and other "underserved" areas. That change substitutes a goal that Freddie Mac met for one that it did not meet. That is, both Fannie Mae and Freddie Mac would have met their central-city goal for 1995 had the 1996 goal been in place.
Both housing GSEs are also conducting large consumer education and outreach efforts, including advertisements in multilingual, audio, braille, and computer formats; telephone hot lines; and home-buying fairs. Despite those intense publicity campaigns, a significant contribution by the GSEs to the nation's affordable-housing goals has yet to be demonstrated. Fannie Mae and Freddie Mac claim that by reducing interest rates on home mortgages, they increase home ownership by all income groups. However, the federal subsidy is responsible for that effect. The housing GSEs are only one of several alternative vehicles for delivering that subsidy. Increased home ownership is not a benefit of using one delivery instrument rather than another.
Recent research conducted at the Federal Reserve Board, however, develops new data and addresses the capacity of the housing GSEs to extend mortgage financing opportunities to lower-income borrowers.(6) The Federal Reserve study begins with an insightful discussion of the component functions of mortgage lending and identifies those that are crucial to the objectives of increasing home ownership by low-income households. According to the study, the functional elements of mortgage lending are:
In today's financial markets, assuming credit risk is the critical function--the binding constraint--in providing a mortgage to a home buyer. Mortgage originators, servicers, and holders are important to the lending process, but the decision to lend hinges on the willingness of some entity to accept credit risk. If a risk bearer can be found, providers of the ancillary functions of lending are readily available.
The principal institutional contributor to the flow of mortgage loans to low-income borrowers, therefore, is the provider of credit-risk services. Although much is known about which institutions provide funding for home mortgages, relatively little had been known about the distribution of credit risk on mortgages until the Federal Reserve study. Potential providers of credit risk on home mortgages include private mortgage insurers; government mortgage insurers, specifically the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA); Fannie Mae and Freddie Mac; and the portfolio lenders, including banks, thrifts, and credit unions.
The Federal Reserve study found that depository institutions bore the credit risk in about 28 percent of the owner-occupied home-purchase mortgages originated in metropolitan areas during 1994. The percentages for other participants in the mortgage markets were 23 percent for the FHA and VA, 17 percent for private mortgage insurers, and 17 percent for Fannie Mae and Freddie Mac combined. In fact, those data probably overstate the true amount of risk that the housing GSEs bear. As the study put it:
Generally, the type of mortgage insured by the FHA or PMI companies is riskier than the type of mortgage for which Fannie Mae or Freddie Mac bear the credit risk. Thus, if one could "weight" mortgage loans by the actual credit risk they pose to the institutions that insure, hold or purchase mortgages, the FHA and PMI companies presumably would bear a proportion of the credit risk that is higher than we calculate.
For mortgages that do not exceed the FHA size limit ($77,197 in most areas of the country in 1994, more in high-price areas) and therefore are more likely to be made to low-income borrowers, the study found that the depository institutions and the Federal Housing Administration bear most of the credit risk.
[The depositories, their affiliates, and the FHA] account for about 56 percent of the FHA-eligible mortgages extended to lower-income borrowers. Fannie Mae and Freddie Mac taken together are the third largest risk holders in this market with a 15.2 percent share of the market, whereas PMI companies as a group bear the risk of 12.3 percent of these mortgages.
The FHA and depository institutions (including affiliates) accounted for about 60 percent of the FHA-eligible mortgages extended to black or Hispanic borrowers. PMI companies accounted for about 14 percent, and Fannie Mae and Freddie Mac accounted for about 10 percent.(7)
Thus, in terms of providing the crucial credit-risk service to low-income and minority borrowers, purely private depositories appear to outperform Fannie Mae and Freddie Mac.(8) That result may not be difficult to explain. Fannie Mae and Freddie Mac largely specialize in mortgage finance for first-quality borrowers rather than in assessing and bearing the credit risk for marginal borrowers.(9) The housing GSEs require private mortgage insurance on all loans with a loan-to-value ratio of more than 80 percent and are generally more likely to require private mortgage insurance on conventional mortgages than are depository holders. Their reluctance to bear credit risk may simply reflect that:
Fannie Mae and Freddie Mac, unlike depositories, generally have no interactions with borrowers and are not located in the neighborhoods where the mortgages are originated; thus they lack the opportunity to look beyond traditional measures of risk.(10)
Even though Fannie Mae has announced its intention to acquire another $1 trillion of mortgages for borrowers "who have not been well-served by our housing finance system--families who earn less than the median income in their area, those living in central cities and rural areas, the elderly, immigrants, first-time home buyers, and others with special housing needs," Fannie Mae apparently does not intend to increase its assumption of credit risk.(11) The GSE's chairman has dismissed suggestions that this initiative, "Showing America a New Way Home," will increase risk at Fannie Mae. Instead, he has said that Fannie Mae will buy mortgages originated to "well-qualified" borrowers. He has also forecast that "loan-to-value ratios are not likely to rise significantly from where they are currently" and that Fannie Mae could adjust price and "would consider further raising mortgage insurance requirements if it became necessary."(12)
The claim by the housing GSEs that the enterprises deliver social benefits
from increasing home ownership by disadvantaged borrowers appears to fail
the institutional capacity test.
Summing Up
The largest claim of public benefit advanced by the government-sponsored enterprises is that they reduce mortgage interest rates. By reducing rates across the spectrum of conforming mortgages, they claim to increase the ability of low-income borrowers to qualify for a mortgage of a specified size. That claim misstates the role of the housing GSEs in determining interest rates. Fannie Mae and Freddie Mac receive a federal subsidy that they are expected to pass through to home buyers. They are not the source of that benefit. Rather, the housing GSEs are a vehicle for conveying a subsidy to intended beneficiaries. The estimated ratio of retained to passed-through subsidies suggests that GSEs are a high-cost form of delivery.
Stabilizing mortgage markets is another public benefit claimed by Fannie Mae. But it is clear that either the housing GSEs provide no more stabilizing effects than fully private intermediaries or they are being asked to violate their responsibilities to shareholders. In the first case, no public benefit accrues that would warrant taxpayer support; in the second case, no assurance is possible that the government-sponsored enterprises will continue to sacrifice their responsibility to shareholders.
Finally, the housing GSEs claim to provide public benefits in contributing
to the nation's affordable housing goals. That contribution is over and
above any effect that the pass-through of interest rate subsidies would
achieve. Yet evidence is lacking that this benefit exceeds what could be
accomplished by fully private firms and by various levels of government
with the funds that governments would receive following the repeal of the
special exemptions afforded to the GSEs under current law. The housing
GSEs appear to have no special institutional capacity for providing low-income
borrowers with what they most need to get a loan--acceptance of credit
risk. In sum, scant evidence exists of public benefits from the GSEs that
would justify a retained taxpayer subsidy that is more than $2 billion
annually.
1. Title XIII (Federal Housing Enterprises Financial Safety and Soundness Act of 1992), subtitle D, sec. 1381 and 1382 of the Housing and Community Development Act of 1992, amending 12 U.S.C. 1451 and 1716.
2. Statement of Alan Greenspan, Chairman, Federal Reserve Board, before the Senate Banking, Housing and Urban Affairs Committee, June 21, 1990. For a discussion of the development of securitization, see Robert Cotterman and James Pearce, "The Effects of FNMA and FHLMC on Conventional Fixed-Rate Mortgage Yields," HUD Studies (May 1996), pp. 103-112.
3. Federal National Mortgage Association's review of Benjamin E. Hermalin and Dwight M. Jaffee, "The Privatization of Fannie Mae and Freddie Mac: Implications for Mortgage Industry Structure," HUD Studies (May 1996), p. 331.
4. Freddie Mac, 1994 Annual Report (April 1995), p. 13.
5. Susan Wachter and others, "Implications of Privatization: The Attainment of Social Goals," HUD Studies (May 1996), pp. 339-340.
6. Glenn B. Canner and Wayne Passmore, "Credit Risk and the Provision of Mortgages to Lower-Income and Minority Homebuyers," Bulletin, Board of Governors of the Federal Reserve System (November 1995), pp. 989-1016.
7. Canner and Passmore, "Credit Risk and the Provision of Mortgages," p. 1003.
8. Wachter and others also raise the possibility that "private conduits that specialize in underwriting and securitizing these [low-income] loans may be better able to price their risk." See "Implications of Privatization," p. 353.
9. As noted, Fannie Mae has described its "most important function" and "essential mission" as "that of providing liquidity--at all times and in all places--to the mortgage market."
10. Canner and Passmore, "Credit Risk and the Provision of Mortgages," p. 1006.
11. Fannie Mae, 1994 Annual Report (April 1995), p. 2.
12. "Fannie's Chief Staking Name on $1 Trillion Challenge," American Banker (February 5, 1996), pp. 14, 15.
