Sunday, September 02, 2007

Jim Hamilton writes from Jackson Hole about GSEs

One of the (many) great things about getting to participate in the Jackson Hole conference was getting to meet Jim Hamilton, along with his wife, Marjorie Flavin, both of whose work I have admired for some time.

Jim makes a connection between the GSEs and the current mortgage crisis.

The problem is that we really need the GSEs to step in and help right now (I think Jim's comments suggests that he agrees with this), but we don't want to write a big fat check to Fannie and Freddie.

Perhaps the thing to do is embodied in a comment I wrote on a paper by the USC gang for a Brookings Volume:

"The United States has idiosyncratic institutions whose purpose is to provide capital to mortgage markets while not originating loans. Two of these institutions, Fannie Mae and Freddie Mac, are among the largest financial intermediaries in the world, with assets of about $800 billion each.[i] Each company guarantees well over $1 trillion of off-balance-sheet mortgages.[ii]

Beyond being large, both of these companies are highly profitable, with typical book returns on equity of 25 percent.[iii] Critics of the firms argue that, on a risk-adjusted basis, they are too profitable.[iv] Specifically, they argue that shareholders whose debts are implicitly guaranteed by the U.S. government should not earn such large returns.

The size and profitability of the companies are likely the reason that they are required to meet affordable housing goals. The original charters of the companies were silent on the issue of affordability. Rather, they emphasized stability, liquidity, and ubiquity.[v] It was not until 1992, with passage of the Federal Housing Enterprises Financial Safety and Soundness Act, that Fannie Mae and Freddie Mac faced a regulatory requirement to target mortgage funding to “low- and moderate-income” borrowers, to “underserved” census tracts, and to “very low-income” borrowers or low-income borrowers in “low-income” areas. It is not a stretch to think that Congress felt that, in light of the companies’ special status and profitability, they had a special obligation to help those at the margins of the housing market. These targets became known as the “affordable housing goals.”

The paper by An, Bostic, Deng, and Gabriel asks a very simple question: Did the regulatory requirements put in place in 1992 work...

...[An, Bostic, Deng, and Gabriel’s] results taken as a whole imply that the affordable housing goals have accomplished little in terms of directing mortgage capital to the “underserved.” One could look at the goals as a classic outcome predicted by the public choice literature, which argues that government attempts to cure distortions that it created itself with other distortions.[i] In this particular case, regulators are trying to “cure” a distortion that arises from the existence of Fannie Mae and Freddie Mac: an unnaturally high return on equity to the shareholders of these two companies. This distortion arises from the perceived backing that the two companies receive from the federal government.[ii]

The purpose of the goals is to tax the companies and send shareholder benefits to underserved borrowers and neighborhoods. Structured as they are, however, the goals may simply shift profits from Fannie and Freddie shareholders to mortgage originators. An unusually explicit example of this happened in 2003, when Freddie Mac paid Washington Mutual $6 billion to “borrow” mortgages for goal-counting purposes.[iii] This transaction did nothing to add liquidity to the mortgage market anywhere and yet was a perfectly rational reaction by both parties to the goals.

The problem with the goals is that they do not tackle the distortion created by the existence of Fannie Mae and Freddie Mac in a head-on manner. The companies earn large profits because they are allowed to borrow at low risk-adjusted interest rates. Moody’s, for example, notes that it gives Freddie Mac an Aaa rating in part because of “dependence between Freddie Mac and the U.S. government.”[iv] In fact, Moody’s states that the default risk of Freddie Mac’s portfolio is at the level of an Aa1-rated financial institution. This is an excellent credit rating and reflects well on the management of the company, but it is still lower than Aaa: the company thus borrows at a lower rate than its credit characteristics warrant.

Congress could tackle this problem directly in one of two ways. It could raise the capital requirements for both companies, or it could follow the suggestion of Glaeser and Jaffee or Jaffee and Quigley and tax Fannie Mae’s and Freddie Mac’s issuance of new debt.[v] The second solution is particularly appealing, because it preserves the ability of Fannie and Freddie to guarantee mortgages—something that has been good for mortgage consumers in the United States—while reducing, if not completely eliminating, the ability of the companies to arbitrage their favorable borrowing position. The money raised via a debt tax could, in turn, be funneled into the Section 8 rental voucher program and, as such, could directly assist those facing the greatest housing needs.

To make this concrete, consider the impact of a 20-basis-point fee on the issuance of new debt. If the companies have at any one time $1.5 trillion in debt outstanding and turn debt over every three years, such a fee would produce $1 billion in revenue each year. This would allow for a $2,000 housing subsidy for 500,000 low-income renter families. Compared to what is currently in place, this is surely a more effective and efficient policy.

[i]. Neither Fannie Mae nor Freddie Mac has issued current financial statements. According to their most recent restated financial statements, each of the companies has more than $800 billion in assets on its balance sheet. For Freddie Mac’s consolidated financial statement for 2006, see [March 2007]. For Fannie Mae’s 2003 consolidated financial statement, see [March 2007]. [ii]. For Freddie Mac, see [March 2008]. For Fannie Mae, see [March 2007].[iii]. The current five-year average return on equity is 24.1 percent for Freddie Mac and 28.9 percent for Fannie Mae. For Freddie Mac, see [March 2007]. For Fannie Mae, see [March 2007].[iv]. See, for example, Frame and White (2005).[v]. For the text of Freddie Mac’s original 1970 charter, see [March 2007]. For the text of Fannie Mae’s original charter, see [March 2007].

[i]. See Tullock (1965) for the classic argument.
[ii]. I have argued that, on balance, this backing has been a good thing, because it creates liquidity in the market for conventional conforming mortgages. See Green (2005).
[iii]. See Berenson (2004a).
[iv]. Moody’s Investor Services (2006).
[v]. Glaeser and Jaffee (2006) and the paper by Jaffe and Quigley in this volume.


Steve Wojnar said...

Your links do not take your readers to the GSE's original charters. They take them to the most current version. The originals are darned near impossible to find. Your link to Freddie's for example, takes readers to a charter that states that 13 of the 18 members of the board of directors shall be elected by the holders of voting common stock. When chartered in 1970, Freddie Mac did not have any common stock. Its shareholders were the 12 FHLB's who put up the capital to create it.

Anonymous said...