Freddie Mac and Fannie Mae
An Exit Strategy for the Taxpayer
by Arnold Kling
No. 106 September 8, 2008
The Fannie Mae-Freddie Mac crisis may have Regulators should contemplate freezing the
been the most avoidable financial crisis in histo- mortgage purchase activities of the GSEs while
ry. Economists have long complained that the at the same time loosening the capital require-
risks posed by the government-sponsored enter- ments for banks to hold low-risk mortgages.
prises were large relative to any social benefits. The result would almost surely be an industry
We now realize that the overall policy of pro- much less concentrated than the current duop-
moting home ownership was carried to excess. oly. A housing finance system that does not rely
Even taking as given the goal of expanding home so heavily on Freddie Mac and Fannie Mae will
ownership, the public policy case for subsidizing be more robust.
mortgage finance was weak. The case for using We have to assume that sooner or later some
the GSEs as a vehicle to subsidize mortgage of the institutions involved in mortgage finance
finance was weaker still. The GSE structure serves will fail. The policy should be to promote a hous-
to privatize profits and socialize losses. And even ing finance system where mortgage risk is spread
if one thought that home ownership was worth among dozens of institutions. That way, the fail-
encouraging, mortgage debt was worth subsidiz- ure of some firms can be resolved through merg-
ing, and the GSE structure was viable, allowing ers and orderly restructuring, without exposing
the GSEs to assume a dominant role in mortgage the financial system to the sort of catastrophic
finance was a mistake. The larger they grew, the risk that is represented by Fannie Mae and
more precarious our financial markets became. Freddie Mac.
Arnold Kling is an adjunct scholar with the Cato Institute. After receiving his Ph.D. in economics from the Massachusetts
Institute of Technology, he worked as an economist at the Federal Reserve Board for six years and then at Freddie Mac for about
10 years in the 1980s and 1990s. He blogs at econlog.econlib.org.
Cato Institute • 1000 Massachusetts Avenue, N.W. • Washington, D.C. 20001 • (202) 842-0200
The GSE crisis mark notes in 2000 and triple what it
may have been Introduction paid in June 2006.1
the most The United States Congress has a genius The story goes on to note that the market was
avoidable for creating government programs that are treating the debt of Fannie Mae and Freddie
difficult to terminate. For example, with Mac as if it were rated A2 by Moody’s. The
financial crisis Social Security and Medicare, there is no way actual rating on the debt is AAA, and histori-
in history. to cut taxes on current workers without cally investors priced it that way. But, alarmed
threatening the benefits of current recipients. by large losses and thin capital shields at the
There is no pool of accumulated assets that GSEs, investors began to contemplate the risk
can be used to pay beneficiaries, the myth of of a GSE default.
trust-fund accounting notwithstanding. Once this risk was priced into their debt
Similarly, the mortgage market duopoly of instruments, the two firms’ borrowing costs
Freddie Mac and Fannie Mae, which five years soared, placing them in jeopardy.
ago held over half of the outstanding mort- The loss of confidence in the GSEs, which
gage debt in the United States, is difficult to spread to the stock market, could quickly have
terminate. They cannot be merged with other driven them into bankruptcy. Had the Treasury
financial institutions, because those other and Congress failed to act, a GSE default would
institutions lack the special borrowing privi- have become a self-fulfilling prophecy. The con-
leges that the government-sponsored enter- sequence of the hastily passed late-summer leg-
prises (GSEs) enjoy. islation is that if the housing market gets worse
In fact, the reaction of Congress to the cri- or if it turns out that the less-than-transparent
sis created by subprime mortgage defaults was portfolios of the GSEs contain hidden weak-
to expand the role of the GSEs in mortgage nesses, taxpayers could be liable for tens of bil-
finance. Each mortgage purchased by one of lions of dollars in shortfalls.
the GSEs would have been limited to no more In this briefing paper, I will suggest ways
than $417,000, except for emergency legisla- that Congress could gradually extricate hous-
tion last December raising the limit to ing policy from its dependence on the GSEs.
$729,750. Indeed, in the first quarter of this While it may be too late to insulate taxpayers
year, the GSEs funded 70 percent of new mort- from the risks embedded in the GSEs’ current
gages. portfolios, it is possible to shrink the GSEs
Early in July, there was an abrupt collision without significantly damaging the housing
between congressional intent and market market.
reality. On July 9, Bloomberg reported that: Three questions are worth examining:
Fannie Mae paid a record yield over 1. What policies might have prevented the
benchmark rates on $3 billion of two- crisis?
year notes amid concern that the U.S. 2. How does the recently passed legisla-
mortgage-finance company doesn’t tion deepen government involvement
have enough capital to weather the in housing finance?
biggest housing slump since the Great 3. Going forward, how could government
Depression. extricate itself and the GSEs from a dom-
The 3.25 percent benchmark notes inant role in the housing market?
priced to yield 3.27 percent, or 74 basis
points more than comparable U.S.
Treasuries, the Washington-based com- An Avoidable Crisis
pany said today in an e-mailed state-
ment. That’s the biggest spread since The GSE crisis may have been the most
Fannie Mae first sold two-year bench- avoidable financial crisis in history. Economists
How Do the GSEs Work?
The GSEs operate in what is called the secondary mortgage market. That is, they
purchase mortgage loans from other sources. As a home buyer, you cannot obtain a
mortgage directly from Freddie Mac or Fannie Mae. Instead, you obtain your loan from
someone in the primary mortgage market (a bank or a mortgage banker), and that
lender sells the loan to one of the GSEs. The GSEs then combine your mortgage loan
with similar loans into what are called mortgage pools. These pools are formed into
pass-through securities, meaning that the principal and interest on the mortgages in
the pool are passed through to investors in the securities. The GSEs can either sell the
mortgage-backed securities to other investors or retain the securities for themselves. In
the 1990’s, Freddie gradually shifted from a strategy of selling most of its securities to
a strategy of retaining most of its securities. Fannie has always predominantly held its
securities in its portfolio. Whether it retains or sells the security, the GSE bears the
default risk of the mortgages, which is the source of the recent crisis.
The GSEs take responsibility for ensuring that all the principal and interest on the
underlying mortgages is returned to investors, even if the mortgage borrowers them- long complained
selves default on their loans. If a borrower defaults, the loan is removed from the pool. that the risks
The GSE pays the full principal amount to the holders of the security and then recov-
ers what it can from a foreclosure sale. When this happens, the GSE typically absorbs a posed by the GSEs
loss of about half the outstanding principal on the loan. were large relative
The GSEs charge a fee, known as a guarantee fee, that on average is sufficient to cov-
er their losses and provide a profit. If the primary lender offers you a mortgage loan at
to any social
an interest rate of 6.75 percent, the GSE may put the loan into a security that pays 6.50 benefits.
percent. The remaining 0.25 percent is retained by the GSE as its guarantee fee.
GSEs earn profits in two ways. First, the guarantee fee is typically larger than what
is needed to cover the cost of mortgage defaults. This is called their mortgage insurance
business, because the GSEs are providing insurance to investors against mortgage
defaults. Second, when the GSEs retain securities rather than selling them, they earn a
financing profit. If a GSE retains a security that yields 6.50 percent and it can finance
that security by issuing debt that costs only 6.25 percent, then the GSE earns a spread
of 0.25 percent. This is called the portfolio lending business, because the GSEs are man-
aging a portfolio of investments in mortgage securities.
In both the mortgage insurance business and the portfolio lending business, the
GSEs have two important advantages. These advantages are a lower risk premium and
lower capital requirements.
In the capital markets, U.S. Treasury debt is considered risk-free, and every other
borrower pays a higher interest rate than the Treasury. That difference is called a risk
premium. The greater the uncertainty about the borrower’s financial condition, the
higher the risk premium. Because investors believed that the GSEs would not be
allowed to fail, until very recently the risk premium on GSE debt was very low.
The second advantage that the GSEs enjoy is low capital requirements. When banks
engage in the mortgage insurance business or the portfolio lending business, they are
required by their regulators to put more of their shareholders’ funds at risk than the
GSEs are. This makes it difficult for banks to compete with GSEs.
have long complained that the risks posed by Regulators corrected some accounting
the GSEs were large relative to any social bene- flaws that had allowed insolvent institu-
fits. But the GSEs have used political clout to tions to continue expanding. Regulators
beat back attempts to limit their growth. also made changes to the incentive struc-
The growth of the GSEs took place in sev- ture of deposit insurance, forcing riskier
eral stages. An approximate timeline of events banks to pay higher premiums.
is as follows: • In the early 1980s, as the S&Ls were falter-
ing, Fannie Mae was losing a million dol-
• In 1938 the Federal National Mortgage lars a day. Fannie’s problem was rising
Association (ultimately nicknamed Fan- interest rates and a portfolio of long-term
nie Mae) was formed as a government mortgages financed in part by short-term
agency to try to fill some of the gap in the debt. However, Fannie Mae kept growing
mortgage lending industry left by the as its S&L competitors fell by the wayside,
wave of bank defaults in the Great and when interest rates stabilized and
Depression. came down, Fannie Mae became highly
• In 1968, in part to get Fannie Mae’s lia- profitable.
bilities off the government balance sheet, • Also in the early 1980s both Freddie
Fannie Mae was spun off to private Mac and Fannie Mae fed off the carcass-
investors. es of the thrift industry. Freddie and
• In 1970, to deal with regulatory impedi- Fannie engaged in “swap” transactions
ments in getting mortgage money to that allowed S&Ls to liquidate mort-
California, the Federal Home Loan gage portfolios without recognizing
Mortgage Corporation (ultimately nick- losses. In this way, they were able to
named Freddie Mac) was formed as a gov- expand their lending even as they were
ernment agency. failing. With one hand—the GSEs—gov-
• Throughout the 1970s the role of the ernment was handing the S&Ls money
GSEs expanded. The savings and loan to gamble, while with the other hand—
industry, which at the time dominated the Resolution Trust Corporation—the
mortgage finance, was plagued by disin- government was absorbing the losses.
termediation. Regulation Q, which lim- • In 1989, Freddie Mac was sold to private
ited the interest rate that thrifts could shareholders, just as Fannie Mae had
pay to their depositors, was causing an been in 1968. Freddie Mac proceeded to
outflow of funds from the S&Ls. That grow dramatically, and the two GSEs
was another classic example of a govern- held just over 50 percent of all mortgage
ment intervention without a viable exit debt outstanding in 2003.
strategy. Regulation Q was not sustain- • In 1992 Congress created a single regula-
Strong lobbying able. However, lifting that regulation tor, called the Office of Federal Housing
by Fannie Mae would have raised the thrifts’ cost of Enterprise Oversight, to oversee Freddie
funds, making many of them insolvent. Mac and Fannie Mae.
and Freddie Mac Ultimately, the regulation was lifted, and
was sufficient many S&Ls went under, at a cost to tax- Congress never explicitly said that it was
to offset the payers of more than $100 billion. designing a mortgage finance system based
• Regulation Q helped to cause the down- on this duopoly. However, strong lobbying
warnings of fall of the S&L industry. However, the by Fannie Mae and Freddie Mac was suffi-
many public large losses incurred by taxpayers were the cient to offset the warnings of many public
result of flaws in the deposit insurance officials that the dominance of the GSEs was
officials that the system. In response to the losses on the unwise.
dominance of the S&Ls, the government reformed the way Concerns about the GSEs spanned the polit-
GSEs was unwise. that deposit insurance was implemented. ical spectrum. Lawrence Summers, Treasury
Secretary under President Bill Clinton, com- Congress was reluctant to restrain the The overall policy
plained in 1999 of the anomalous status of the market. Instead, even though the GSEs of promoting
GSEs. When the crisis broke this July, Summers were not supposed to purchase high-risk
was understandably bitter. On a web site called mortgages, under pressure from Congress home ownership
Creative Capitalism, he wrote: they bought hundreds of billions of dol- was carried to
lars of securities backed by subprime
What went wrong? The illusion that the loans.
companies were doing virtuous work 2. Even taking as given the goal of expand-
made it impossible to build a political ing home ownership, the public policy
case for serious regulation. When there case for subsidizing mortgage finance
were social failures the companies was weak. Rather than constituting a
always blamed their need to perform for “positive externality,” the heavy load of
the shareholders. When there were busi- mortgage indebtedness posed a major
ness failures it was always the result of systemic risk.
their social obligations. Government 3. The case for using the GSEs as a vehicle
budget discipline was not appropriate to subsidize mortgage finance was weak-
because it was always emphasized that er still. As Summers and others have
they were “private companies.” But mar- pointed out, the GSE structure serves to
ket discipline was nearly nonexistent privatize profits and socialize losses.
given the general perception—now vali- 4. Even if one thought that home owner-
dated—that their debt was government ship was worth encouraging, mortgage
backed. Little wonder with gains priva- debt was worth subsidizing, and the GSE
tized and losses socialized that the structure was viable, allowing the GSEs
enterprises have gambled their way into to assume a dominant role in mortgage
financial catastrophe.2 finance was a mistake. The larger they
grew, the more precarious our financial
However, Summers was far from a lonely markets became. It reached the point
critic of the GSEs. Lawrence J. White, who where the health of the entire financial
served on the board of the agency regulating system appeared to depend on the
Freddie Mac from 1986 through 1989, wrote health of the GSEs.
a study for the Cato Institute in 2004 in
which he advocated full privatization of the
GSEs.3 He suggested having the government The Latest Legislation
disavow any guarantees to GSE investors.
That same year, in Privatizing Fannie Mae, In July 2008, Congress passed comprehen-
Freddie Mac, and the Federal Home Loan Banks: sive legislation aimed at the housing market,
When and How, Peter J. Wallison, Bert Ely, and including some provisions pertaining to the
Thomas J. Stanton proposed that steps be GSEs. The legislation provides for a multi-year
taken to level the playing field so that banks increase in the ceiling on loans eligible for pur-
could compete with GSEs, thereby reducing chase by the GSEs, to $625,000. What is more
the dependency of the housing finance sys- important, in order to restore investor confi-
tem on GSEs. dence in GSE securities, the new law gives the
In hindsight, knowing what we know U.S. Treasury the authority to extend almost
today, we can say that: unlimited credit to the GSEs and even to pur-
chase equity in the companies. Lastly, the leg-
1. The overall policy of promoting home islation creates a new independent regulatory
ownership was carried to excess. By 2006, agency to oversee the GSEs.
the demand for housing had boosted It appears that the intent of Congress is to
prices to unsustainable levels. However, keep the GSEs substantially as they are.
Freddie Mac and Fannie Mae are supposed to existing personnel out of the Department of
continue to add to their portfolios. As long as Housing and Urban Development. Its perma-
their financial condition does not deteriorate nent director will be appointed by the next pres-
radically, the management and ownership ident, and the transition is not expected to be
structure of the GSEs will remain unchanged. complete until at least July of 2009.
In short, the new legislation contemplates
business as usual. The GSEs will continue to
serve as the conduit for an indirect subsidy to Alternatives
home buyers, with GSE shareholders getting
much of the profits and taxpayers bearing The attempt to preserve the status quo is
the costs and, most importantly, the risks. not necessarily the best approach. In a July 27,
2008, newspaper column, Lawrence Summers
compared the Bear Stearns merger with the
Unwise Approach housing legislation:
Current policy treats the GSEs as essential Consider how much more problematic
to U.S. housing finance. That is an unwise the Bear Stearns response would have
The risks involved approach. It makes the housing market unnec- been had policymakers signalled their
in mortgage essarily fragile. It sets up a permanent conflict commitment to back the company’s lia-
lending would be between shareholders and taxpayers, to be bilities without limit; left management
mediated by an untried regulatory agency. in place with no change in the business
better spread The U.S. mortgage market is the largest model; and allowed dividends to be paid
among dozens of financial market in the world. When two and shareholders to keep going with
firms together hold more than one-third of hope for a better tomorrow. Yet all of
institutions, the outstanding mortgage debt, the entire these elements are present in the cases
rather than financial system is fragile. The risks involved of Fannie and Freddie.4
concentrated in in mortgage lending would be better spread
among dozens of institutions, rather than Summers compared the status quo with
the two GSEs. concentrated in the two GSEs. With dozens the GSEs to the S&L crisis of the early 1980s,
of mortgage lenders, the failure of any one where the attempt by Congress and regulators
firm could be dealt with through a merger, to keep the thrifts going ultimately added to
rather than forcing the taxpayers to bear the the taxpayers’ losses. Summers recommends
full brunt of the risk. operating the GSEs as government corpora-
With GSE debt guaranteed by the govern- tions for several years. At that time, he would
ment, there is a conflict between shareholders sell whatever components of the GSEs are
and taxpayers. For shareholders, the way to max- profitable to fully private entities.
imize profits is to borrow at the nearly risk-free I would recommend a strategy that aims
rate (courtesy of the government’s guarantee) in at spreading the mortgage business across a
order to finance risky lending. The incentive is to wider range of financial institutions. In par-
take on a large portfolio with minimal capital. ticular, regulators should contemplate freez-
The goal of protecting taxpayers requires the ing the mortgage purchase activities of the
opposite: stiff capital requirements, with limits GSEs while at the same time loosening the
on portfolio size and risk-taking. Until recently, capital requirements for banks to hold low-
the Office of Federal Housing Enterprise Over- risk mortgages.
sight was charged with implementing capital A freeze would have two beneficial effects.
regulations. It remains to be seen whether under First, in the event that Freddie or Fannie
a new regulator, called the Federal Housing becomes insolvent, the failure will be easier to
Finance Agency, this function will be handled manage if the firm is smaller, with less uncer-
any more effectively. The FHFA merely takes the tainty about the outlook for its mortgage port-
folio. Second, a freeze would lead to an expan- It might be argued that even an increase of
sion of the role of banks and other financial one-fourth of one percentage point in mort-
institutions in the mortgage market, ultimately gage rates is something that public policy
resulting in a stronger mortgage finance system. should seek to avoid. If so, public policy can
As the GSEs continue to purchase new avoid that consequence through a number of
mortgages, their portfolios become more dif- means. One approach to consider would be
ficult for other firms to assess or to absorb. to modify the capital requirements of banks.
New mortgages are the most difficult to assess Banks, like the GSEs, have liabilities that are
in terms of risk. Within a few years, any flaws guaranteed by the U.S. government. Bank de-
in the borrower’s capacity to manage credit posits are insured by the Federal Deposit In-
have been exposed, and the initial trend of surance Corporation. Accordingly, banks have
home prices in the area has been observed. no inherent cost disadvantage relative to the
Once mortgages have been seasoned for sever- GSEs in making mortgage loans. However,
al years, the default rate is usually predictable. banks do have a regulatory disadvantage, based
Assuming that the GSEs’ capital is sufficient on differences in capital requirements. Reducing
to absorb any losses, it would be possible for the or eliminating those differences would allow
government, within 5 to 10 years, to credibly banks to offer mortgage loans at rates that com-
eliminate its guarantee of GSE liabilities. Today, pete with GSE rates.
government cannot limit its guarantee, because The main reason that the GSEs grew to
too many security-holders would be adversely dominate the market for loans that fit their eli-
affected. However, in several years, when the gibility criteria is that their capital require-
financial condition of the firms will be much ments were derived from the default risks of
clearer and the size of their obligations will be the mortgage loans. In contrast, banks have to
much smaller, the blank-check guarantee should hold an amount of capital against their mort-
no longer be needed. Once the guarantee is elim- gage assets that is higher, particularly for those
inated, the GSEs can resume their purchases of mortgage loans with the lowest default risk.
new mortgages. At that point, they would face Bank regulators could, on either a tempo-
the discipline of the capital markets, which rary or permanent basis, reduce the capital
would make it extremely unlikely that their mar- requirements for low-risk mortgages held by
ket shares would reach dangerously high levels. banks. Low-risk mortgages would be mort-
What would a GSE freeze do to the mort- gages where the borrower makes a down pay-
gage market? Other lenders, primarily banks, ment of 20 percent, or 10 percent with mort-
would have to step in and bear the default risk gage insurance. These are the loans that are
and investment risk of mortgages. They tend “conforming loans,” meaning that they fall One approach
to charge higher rates than the lenders who within the GSEs’ charters. Reduced capital
sell their loans to the GSEs. This can be seen in requirements would encourage banks to com-
might be to
the market for so-called “jumbo” loans, which pete more aggressively for those loans, thereby reduce the capital
are mortgages that are larger than the GSEs’ mitigating some of the impact of a freeze on requirements
purchase limits. Historically, jumbo loans new purchases by the GSEs.
have cost about one-fourth of one percentage One approach might be to reduce the cap- for low-risk
point more than GSE-eligible loans. That ital requirements for low-risk mortgages pur- mortgages
would suggest only a modest impact of losing chased over the next three years, so that the
the GSE presence in the mortgage market. housing market can start to recover from the
More recently, however, as mortgage-backed collapse of prices in the past year. After three the next three
investments have acquired a stigma, the spread years, the capital requirements for new mort- years, so that the
between jumbo rates and GSE-eligible rates has gage purchases could be brought back to cur-
widened to a full percentage point. This sug- rent levels, perhaps under a gradual phase-in. housing market
gests that the impact of losing the GSE pres- With or without modifying bank capital can start to
ence could be that large. requirements, freezing GSE purchases would recover.
serve to restructure the mortgage finance sys-
tem. The result would almost surely be an Notes
industry that is much less concentrated than 1. Dawn Kopecki and Bryan Keogh, “Fannie Mae
the current duopoly. A housing finance sys- Pays Record Spreads on Two-Year Note Sale (Up-
tem that does not rely so heavily on Freddie date3),” Bloomberg.com, July 9, 2008, http://www.
Mac and Fannie Mae will be more robust. bloomberg.com/apps/news?pid=newsarchive&sid=a
There is no fool-proof system for handling
mortgage credit risk. We have to assume that 2. Lawrence Summers, “Our Creative Mortgage
sooner or later some of the institutions Crisis?” Creative Capitalism: A Conversation, July
involved in mortgage finance will fail. The pol- 16, 2008, http://creativecapitalism.typepad.com/cre
icy should be to promote a housing finance
system where mortgage risk is spread among 3. Lawrence J. White, “Fannie Mae, Freddie Mac,
dozens of institutions. That way, the failure of and Housing Finance: Why True Privatization Is
some firms can be resolved through mergers Good Public Policy,” Cato Institute Policy Analysis
no. 528, October 7, 2004.
and orderly restructuring, without exposing
the financial system to the sort of catastroph- 4. Lawrence Summers, “The Way Forward for
ic risk that is represented by Fannie Mae and Fannie and Freddie,” Financial Times, July 27, 2008,
Freddie Mac. http://www.ft.com/cms/s/0/b150d388-5bf8-11dd-
OTHER STUDIES IN THE BRIEFING PAPERS SERIES
105. FASB: Making Financial Statements Mysterious by T. J. Rodgers
(August 19, 2008)
104. A Fork in the Road: Obama, McCain, and Health Care by Michael Tanner
(July 29, 2008)
103. Asset Bubbles and Their Consequences by Gerald P. O'Driscoll Jr.
(May 20, 2008)
102. The Klein Doctrine: The Rise of Disaster Polemics by Johan Norberg
(May 14, 2008)
101. WHO’s Fooling Who? The World Health Organization’s Problematic
Ranking of Health Care Systems by Glen Whitman (February 28, 2008)
100. Is the Gold Standard Still the Gold Standard among Monetary Systems?
by Lawrence H. White (February 8, 2008)
99. Sinking SCHIP: A First Step toward Stopping the Growth of
Government Health Programs by Michael F. Cannon (September 13, 2007)
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