Jewish World Review Oct. 14, 2004 / 29 Tishrei, 5765
Lawrence J. White
The trouble with Fannie and Freddie
http://www.jewishworldreview.com | The recent revelation of serious accounting irregularities at Fannie Mae, following last year's accounting scandal at Freddie Mac, once again highlight the size, importance and uniqueness of the two companies. The events are also reminders of the need for fundamental reforms that go far beyond accounting.
Fannie Mae and Freddie Mac are among the five largest companies in the U.S., with combined assets of $1.8 trillion. Their business involves the secondary market for residential mortgages. They buy and hold mortgages in their portfolios, funding themselves overwhelmingly with debt, and they create and swap tradable "mortgage-backed securities" that carry Fannie's or Freddie's guarantee as to timely payment of interest and principal. They currently can buy or guarantee mortgages up to $333,700 in value.
Fannie and Freddie are often described as "government-sponsored enterprises," or GSEs. Though they have stockholders and their shares are traded on the New York Stock Exchange, their corporate charters are the creation of Congress. As a consequence, the two companies enjoy an array of special features and privileges that are directly beneficial to them and that also have created a quasi-governmental "halo" around them. One concrete manifestation of this halo: The financial pages of newspapers list the prices and yields of their debt issues in a special box that is typically labeled "government agency issues."
The effect of the halo, in turn, has been to convince bond buyers that the federal government would likely rescue the companies in the event of financial difficulties. This belief in an "implicit guarantee" gives the GSEs their greatest benefit: They can borrow in the debt markets at interest rates that are more favorable than their stand-alone financial rating would otherwise warrant. This advantage has been estimated to be about four-tenths of a percentage point, which means major cost savings for Fannie (with debt of almost $1 trillion) and Freddie (with debt of over $750 billion).
The two GSEs, in turn, cause mortgages to be a bit cheaper for homeowners - about a quarter of a percentage point cheaper. This off-budget benefit for their constituents, coupled with the GSEs' generous political donations, makes Congress feel warmly toward the GSEs. But the difference between 0.40 and 0.25 has remained with their shareholders, and the two companies' hefty earnings (bolstered by the fees they charge on their mortgage-backed securities) have made their shares popular with analysts and investors. It was efforts to manipulate their accounting so as to provide investors with the appearance of smoothly growing earnings, however, that led to the scandal at Freddie and the recent allegations at Fannie.
The implicit guarantee has recently attracted considerable attention. The mixture of private ownership, the likelihood that the federal government would bail Fannie and Freddie out in the event of financial difficulties, and their relatively thin capital levels (which are the first-line protection against such difficulties) has the potential for encouraging senior managements to take undue risks, which would favor their shareholders on the upside and would prove costly to the government on the downside. It was exactly this mixture that cost taxpayers about $150 billion as a consequence of the 1980s savings and loan debacle.
Congress did recognize this possibility when it created a special safety-and-soundness regulator (the Office of Federal Housing Enterprise Oversight) for Fannie and Freddie in 1992. But OFHEO has been weak and often politically outmaneuvered by the two companies. Further, future competition for Fannie and Freddie's markets, which is likely to come from major banks and from secondary mortgage market programs at the Federal Home Loan Bank system, will increase Fannie and Freddie's incentives to take risks, warranting tougher regulatory scrutiny.
The best way out of this mess would be to privatize them fully: convert their special congressional charters to ordinary Delaware charters and cease all of their special privileges. Though future mortgage rates might increase a quarter percent, that likely would not dampen the aspirations of too many potential homebuyers. And the GSEs' off-budget arrangement should be replaced by explicit on-budget programs that would target low- and moderate-income first-time homebuyers with down-payment and monthly-payment assistance.
In the event that Congress doesn't have the will for such a true privatization, then the regulatory arrangements must be toughened. OFHEO needs to be moved out of HUD and into Treasury, where the culture and expertise concerning safety and soundness is much stronger, and its powers must be strengthened. Foremost should be giving it the power to place either company into receivership if it cannot satisfy its obligations. Senior managements will thereby know that they cannot pursue risky strategies indefinitely, and bondholders will come to believe they will bear the losses from failed strategies. To reinforce the latter belief, the Treasury must loudly and repeatedly proclaim its intention not to bail out the companies (or their creditors) in such an event.
The accounting difficulties at Fannie and Freddie provide a rare opportunity for achieving fundamental change. A failure to seize that opportunity could well prove costly to taxpayers.