By Warren Coats[1]
Should Uncle Sam have bailed out Fannie Mae and Freddie Mac and what should he do now?
Fannie and Freddie were created by the government to promote home ownership by lowering the cost of home mortgages. Whether it is good public policy to subsidizes home ownership in this and other ways is a separate issue. Fannie, and later Freddie, lowered the cost of mortgages by raising mortgage financing in the market at lower interest rates than previously possible. They reduced borrowing costs to home owners because they were able to borrow in the market in their own names at the risk free interest rates paid by the government and to pass the savings on to the mortgagees. After Fannie was privatized in 1968, it began to raise funds in the market with minimal risk by selling claims to pools of mortgages that met clearly stated minimum underwriting standards.[2] It guaranteed (insured) that private investors would receive the expected principle and interest payments on the underlying mortgages in each pool. Not only did the pooling and guarantee reduce the risk to market investors in such mortgage backed securities (MBSs), but the market fully trusted Fannie’s and later Freddie’s guarantees because of the widely held view that the government would not let them fail (implicit—now explicit—government guarantees).
These low funding costs could be passed on to ultimate mortgagees with lower spreads (the difference between Fannie and Freddie’s cost of funds and the rate they charged home owners) because of F&Fs high leverage. Fannie and Freddie were granted much lower capital requirements than other financial intermediaries. Investors didn’t worry about F&F’s small capital because of the implicit government guarantee of F&F obligations. These advantages over the competition allowed Fannie and Freddie to deliver very large amounts of relatively low cost funds to home buyers.
Why should we care if this arrangement channels more and cheaper financing to homeowners? The history of state owned banks almost every where they have existed in the world has been bad. For obvious political reasons, they are usually greatly overstaffed (with friends of the ruling party) and hold higher levels of non performing loans than privately owned banks as a result of politically motivated loans and poor management. It is too easy and tempting for politicians to push off the costs of government programs, such as loans to subprime borrowers with low or even zero down payments, to such institutions (off-budget expenditures).
Thus the privatization of Fannie Mae in 1968 should have been welcomed. Unfortunately, however, what was privatized was Fannie’s profits but not its risks. The same mistake was repeated with the later creation, then privatization, of Freddie Mac to provide more competition when the more sensible policy would have been to remove Fannie Mae’s special privileges (especially its very low capital requirement). As privately owned companies, F&F have taken a significant amount of their income to pay high dividends to their private owners,[3] very high salaries to their management,[4] and large payments for lobbying services.[5] These payments reduced the extent to which they were able to lower the cost of home ownership. According to The Economist “it has been an awful deal for the tax payer – a Fed economist calculated the implicit debt-guarantee was worth a one-off sum of between $122 billion and $182 billion. Because Fannie and Freddie barely lowered the cost of borrowing, little of this subsidy went toward busting home ownership. Instead, just over half—about $79 billion—went straight to their share holders.”[6]
Worse yet, the “The Department of Housing and Urban Development sets ‘affordable’ housing goals for Fannie Mae and Freddie Mac to dedicate a given amount of credit to poorer homeowners. One way Fannie and Freddie fulfilled these goals was to buy subprime mortgage securities — many of which have now gone bad.”[7] In other words, congress has pushed the cost of one of its programs off the government’s budget onto F&F, backs which is now coming back to the taxpayers.
Between them Fannie and Freddie guarantee two fifth of America’s 12 trillion dollars in mortgages by either owning them or packaging and reselling them to the market as mortgage backed securities of one sort or another. Stated differently three fifths of American mortgages have been financed without Fannie and Freddie’s help.
Basically F&F now provide investment banking services and guarantees to investors in mortgage back securities. But their guarantee, which should be backed by the capital provided by their private shareholders and their due diligence in vetting compliance with the stated underwriting standards, are actually backed by American tax payers. They do nothing that the private market cannot and is not doing already. They do it somewhat cheaper because the tax payer bears the ultimate risk of losses. For many many years a long list of economists and public servants have recommended breaking them up and or getting rid of them[8] and congress has delayed taking action until the latest Fannie and Freddie crisis of this last week.
Congress’s housing bill, signed by President Bush July 30, 2008, strengthened emergency arrangements by the Federal Reserve and the U.S. Treasury to open credit lines to F&F after their share prices collapsed on July 7, following an analysis by Lehman Brothers that potential accounting changes could leave their capital $75 billion short.[9] The new law confirms the Treasury’s pledge to provide liquidity against mortgage collateral and even capital if needed. In other words, the government’s implicit guarantee of F&F liabilities has been made explicit. F&F’s share prices immediate recovered following the earlier Treasury and Fed announcements. These steps were necessary because a loss of confidence in the market in F&F’s mortgage guarantees would freeze trading of, and/or cause very large losses in the value of, the $5.2 trillion mortgages guaranteed by F&F. This could do irreparable damage to the mortgage market and financial markets more broadly. It is impossible to know at this point whether F&F really needs any of this money, which depends on whether mortgage defaults over the next few years are more or less serious than now assumed.
The new law also provides much needed strengthened supervision of Fannie and Frieddie, but there are worrying signs that the underlying problems are just being postponed for yet another bailout rather than being fixed. F&F, along with Ginnie Mae,[10] will continue to have social responsibilities that potentially put tax payers at risk. At the same time that the new law authorizes tax payer money to cover F&F losses, it also taps future income (starting in 2010) to fund a new National Housing Trust Fund. Rather than liquidating F&F, congress has provided for the financing of the new NHTF with yet another off balance sheet scheme that builds a political constituency for the perpetuation of Fannie and Freddie. David Broder declared this an example of “lawmaking as it should be.” [11]
What should be done?
The government should stand ready to provide whatever capital Fannie and Freddie need to honor their existing obligations (and to provide adequately collateralized liquidity). However, such capital injections should come only after all shareholder capital has been used up. The condition for tax payer funded capital should be the surrender of current owners’ shares (a nationalization ala Northern Rock in the UK). Shareholders would lose everything in this case but all other obligations would be met. Once back in government hands these institutions should be gradually liquidated in an orderly way over a number of years.[12] Though investors in F&F guaranteed mortgage backed securities would be bailed out, shareholders would not. This compromise would retain considerable market discipline and is essentially the approach taken with failing banks, which are taken over by the FDIC and often resold over the same weekend. It is the approach advocated by Alan Meltzer for investment banks now that they have access to Federal Reserve credit.[13]
Refusing to bail out shareholders while protecting depositors (in the case of banks) and other creditors (mortgage backed securities in the case of Fannie and Freddie) is a compromise. Market discipline of investors in F&F guaranteed mortgage backed securities from potential loss in bankruptcy of F or F would be reduced, though it would be gradually transferred to privately guaranteed mortgages after the liquidation of F & F. However, full market discipline would be retained for shareholders who are in the best position to control the behavior of these institutions anyway. This is generally as much market discipline publics around the world are willing to accept, but we should insist on nothing less.
[1] Warren Coats, Bethesda, MD, retired from the International Monetary Fund in 2003 as Assistant Director of the Monetary and Financial Systems Department, where he lead technical assistance missions to central banks in over twenty countries. Prior to that he served as visiting economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at UVa from 1970-75. He is currently a director of the Cayman Islands Monetary Authority, Senior Monetary Policy Advisor to the Central Bank of Iraq for BearingPoint, an IMF consultant to both the central bank of Afghanistan, and to the Palestine Monetary Authority, and an Asian Development Bank consultant to the National Bank of Kazakhstan on inflation targeting. In 1989 he coauthored the World Bank’s World Development Report on “Financial Systems and Development.” His most recent book, One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina, was published in November 2007. He has a BA from UC Berkeley and a PhD from the U. of Chicago in Economics.
[2] The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered by the government in 1970 and “privatized” in 1989.
[3] For the year ended December 31, 2005, before the beginning of the current housing and mortgage crisis, Fannie reported profits of almost $6 billion from $50 billion in revenues. According to the Economist (July 19-25, 2008) a Federal Reserve economist “calculated the implicit debt guarantee [of Fannie and Freddie by the government] was worth a one-off sum of between $122 billion and $182 billion.” With just over half going to shareholders rather than lower borrowing costs to home buyers.
[4] “CEO Daniel Mudd received $12.2 million in total compensation last year [2007], down 15 percent from 2006,” when he received $14.45 million. Reuters January 31, 2008. In 2004, 20 of Fannie Mae’s top executives “received more than $1 million each in total compensation in 2002. Twelve received more than $2 million. Nine received more than $3 million.” Washington Post October 11, 2004. Fannie’s chairman and chief executive at that time, Franklin D. Raines, was subsequently fired over accounting “irregularities” that bolstered his and other executives’ performance bonuses.
[5] Fannie and Freddie reported lobbying expenditures over the last ten years of $167 million. The power and effectiveness of their lobbying efforts are legend.
[6] The Economist, “Twin Twisters” July 19, 2008 p 15.
[7] Robert J. Samuelson, “The Homeownership Obsession”. The Washington Post, July 30, 2008 p A15
[8] Peter Wallison has been a particularly articulate and persistent critic of F&F. Also see the resent article by William Poole, "Too Big to Fail, or to Survive" , NY Times, July 27, 2008
[9] Catherine Clifford, “Fannie Mae and Freddie Mac Plunge,” CNNMoney.com, July 7, 2008: 6:36 PM EDT
[10] Government National Mortgage Association, guarantees with the full faith and credit of the Federal Government pools of mortgages collateralize with loans insured or guaranteed by the Federal Housing Administration (FHA) the Department of Veterans Affairs (VA) the Department of Agriculture’s Rural Housing Service (RHS) and the Department of Housing and Urban Development’s Office of Public and Indian Housing (PIH).
[11] David S. Broder, “When Congress Works,” The Washington Post, July 31, 2008, P A19
[12] An alternative would be the outright nationalization of F&F compensating the shareholders with the estimated value of their shares (which might be negative). If later recovers from liquidation are greater than expected, shareholder compensation could be increased at that time. The government would accept the risk that it was less.
[13] Allan H. Meltzer. “Keep the Fed Away From Investment Banks” The Wall Street Journal, July 16, 2008; Page A17
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