It was 2005 and my Uncle was deeply bearish. The housing market was booming but he thought everything was overpriced. Worse still, Fannie Mae and Freddie Mac had insured over five trillion dollars of US mortgages, and should housing prices descend from there stratospheric levels, the US taxpayer was potentially on the hook.
"But aren't Fannie and Freddie private companies?" I asked as a bright-eyed seventeen-year-old while my dad flipped burgers on the grill.
"Yes." He replied.
"And no. Investors have always assumed that since both companies were chartered by Congress, the Federal government would rescue them if they got into trouble."
Back then I knew nothing about funding advantages, interest rate risk, fully sovereign currencies, or retained portfolios. But three summers later, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation were placed into "conservatorship" by then US Treasury Secretary Henry Paulson. At the time, I didn't understand the implications of this bold but necessary move. Today, I realize that conservatorship were the best thing to ever happen to the GSEs, and that seven years later, in 2015, we don't need GSE reform so much as a formalization of legal arrangements which preserve the current status quo.
Nominally Private:
In testimony before the Financial Crisis Inquiry Comission, former Fed Chairman Ben Bernanke descibed Fannie and Freddie as 'nominally private.' Specifically:
Fannie and Freddie were nominally private corporations, but they enjoyed
cost advantages from the implicit federal guarantee on their
liabilities; these cost advantages allowed them to act as a duopoly in a
number of businesses [....] Fannie and Freddie were permitted to operate with capital that was both
of low quality and of inadequate size to buffer the risks in their
portfolios. In addition, their balance sheets were allowed to grow
rapidly.
While Bernanke does not explicitly draw the connection, much of the growth of the balance sheets at the GSEs was specifically because of the strong market demand for their guarantees, a fact not lost of GSE executives. In fact, so confident were the GSEs that they could access the money markets that they frequently began the business day with a negative cash balance which was made up by intraday borrowing. Only a government entity could ever expect to have such seamless access to the money market.
The truth of the matter is, both GSEs could never has grown as large or operated with the levels of margin that they did without government involvement. However, under the system of allowing the GSEs to issue publicly traded shares and operate largely as normal corporations, we ended up with the worst of both worlds. In essence, Freddie and Fannie were forced to serve two masters. They were compelled to make as much money as possible for shareholders, which meant exploiting their government granted privileges to the fullest. While their implicit government backing meant that profits would be privatized and losses would be socialized.
Monetary Policy:
But even more bizarrely, both GSEs even gained the power to engage in de facto monetary policy. With the ability to borrow large sums on the short term money market at the same rate as the government, both GSEs were able to finance gigantic retained portfolios which at their height had notional values in the trillions. Again, because investors believed Agency debt to be as good as US Treasury debt, there was practically no limit to the amount the GSEs could borrow in order to finance mortgage investments. In essence, the GSEs were swapping short term liabilities (Agency debt) for long term assets (mortgage bonds). This is very similar to quantitative easing, whereby the central bank removes long term government debt from the market place and replaces it with short term assets (usually reserves). The effect of both policies was to markedly reduce long term borrowing costs. In fact, a 2006 report written by the CEOs of both Freddie and Fannie openly brags that large retained portfolios were materially reducing long term interest rates by keeping bond prices high.
Monetary policy ought to be the purview of the Fed, and should be conducted with the goals of economic stability, not profit. Nothing stops the Fed from running up its balance sheet as much as it wants to increase its earnings. And maybe if the Fed had shareholders to answer to, it might let its balance sheet balloon to the tens of trillions. But if Congress ever had the bright idea to make the Fed list on the NYSE, we would have nobody to blame but ourselves if when inflation got too high, the Fed put earnings ahead of price stability.
Instead of feigning outrage or surprise at the over-leverage and gigantic balance sheets at both GSEs prior to the crisis, policy makers should take note that both Freddie and Fannie responded in a highly predictable way to the incentives that they were provided. Their mandate was not to stabilize the housing or mortgage markest, rather, it was to maximize mortgage originiations and securitization to boost profits as their balance sheets, both in terms of direct mortgage investments and insuranced mortgages, grew to truly epic proportions.
Dual Roles:
Perhaps a bit of history is important. In 2008 it was easy to say that Freddie and Fannie never should have been chartered. A more insightful line of inquiry would be to examine why the government ever got involved in the mortgage business in the first place.
Mortgage lending is tricky for traditional underwritiers mainly because of interest rate risk. Since banks finance the majority of their assets with demand deposits, writing long term mortgages can result in large amounts of asset liability mismatch. In layman's terms, it's pretty risk to lend money to borrowers for 30 years while you might need to payback your depositors at moment's notice. The beauty of securitiziation is that it allows traditional underwriters such as banks to make mortgage loans and then sell off the interest rate risk to investors in mortgage backed securities. In fact, most so-called portfolio lenders, or those which both originate and retain mortgage loans, offer mainly adjustable rate mortgages. They don't have the capacity to bear the interest rate risk. Without securitization, and without the GSEs, the 30 year fixed rate mortgage would not exist.
On the other hand, most MBS investors are large pension funds, life insurance companies, or sovereign wealth funds. These investors usually have long term liabilities. Most life insurance holders won't die for a long time, and most people involved in a pension scheme won't retire for decades. These investors are therefore perfectly happy to invest in long dated assets.
The GSEs are a fairly basic arrangment. Traditional underwriters originate the loans, but again, since they can't take interest rate risk, they sell the loans off to investors. The GSEs underwrite the process and also insure against the credit risk. The result is that borrowers have access to long term (30 years) mortgage financing. In theory, this same set up could be used to create a market for 30 year car loans, or 30 year personal loans, or 30 year loans to buy dishwashers. Because the credit risk is stripped away, the investors who bear the interest rate risk will be indifferent to the to underlying colateral.
Therefore, because of the implicit government guarantee, Agency MBS have evolved into gross substitutes for US Treasury bonds. The GSEs serve dual roles for different groups. They help home buyers by providing long term fixed rate financing. But they also help satisfy investor demand for long term government liabilities by effectively enlarging the size of the Treasury market. Indeed, after Treasurys, the Agency MBS market is the biggest and most liquid bond market in the world.
The dual role of the GSEs can only be achieved with government involvement. No entity other than the US Treasury itself on Agencies explicitly backed by it can provide risk free dollar denominated securities to worldwide investors. Similarly, satiating this strong investor demand while simultaneously achieving the socially desirable goal of providing flexible borrowing terms to homeowners is a feat of financial engineering that the private sector would never provide. In no other market do 30 year fixed rate mortgages exist. Even in the UK, which has one of the most developed financial sectors in the world, mortgage loans typically have balloon payments after three to five years precisely because the British government is not involved in the making of mortgage loans.
Conservatorship:
Many believe that perpetual conservatorship is a step backwards for the GSEs, but in reality, conservatorship merely formalized an implicit structure which was crucial to achieving both of the their dual roles. As effective public monopolies and quasi-sovereign securities issuers, it was incredibly misguided to involve the private market at all with either Fannie or Freddie. Neither should have been publicly listed on stock exchanges. The inevitable result was that both enterprises would put profits ahead of financial stability, and would exploit there public monopolies not to achieve the public purpose of providing safe investment vehicles and access to mortgage credit, but to make money for investors.
In fact, in the heyday of Fannie and Freddie, both became more and more involved in riskier lending products which in hindsight destabilized the mortgage market and did not benefit borrowers. Their securities issuance business was soon accompanied by highly leveraged trading operations which traded MBS on the GSEs' own account rather than on the behalf of clients. That's right, Freddie and Fannie engaged in so called proprietary trading, a practice thought to have contributed greatly to the systemic risk which built up in the financial sector prior to the crisis.
Going forward, conservatorship provides a perfect model for both GSEs. Most importantly, it removes the perverse incentives and conflicting goals that the GSEs had before the crisis, namely, the need to please shareholders but also to responsibly use their government granted priviledges for public purpose and not short term profit.
Conservatorship also provided stability to the credit markets. Mortgage markets did not stop working in 2009. In fact, the GSEs have securitized trillions of loans since the crisis. Had the mortgage market been left the private sector, it would have essentially ceased to exist after the fallout from the crisis. This in turn would have made the economic downturn even worse. Given the primacy of housing in the economy, it is nothing short of reckless to leave the goals of homeownership and the financing necessary to achieve it to the vagaries of the market.
If the GSEs were made explicit agencies of the US government, the risk to the taxpayer would be essentially zero. This is because the all mortgage debt in the US is denominated in US dollars, of which the US government is the issuer. Specifically, the cost of government spending is an opportunity cost. Real resources marshalled for public purpose cannot be put to private use. However, goverment spending to make financial transactions, such as paying off bond holders, involve no such relagation of private sector wealth to the state. Therefore, even massive purchases of securities of by the government, even when financed by money creation, is unlikely to cause inflation. Indeed, after nearly four trillion dollars of quantitative easing inflation is still at historic lows. To put things in perpsective, the GSEs drew a combined 187 billion dollars from the Treasury. This event occured after the worse economic downturn since the great depression and on a combined balance sheet of over five trillion dollars of mortgage assets. Furthermore, all of the money and then some has been paid back to the Treasury. And even if the losses had been more severe, nothing would have stopped the government from simply creating the dollars necessary to pay the bond holders with little risk of inflation. So much for risk to the taxpayer.
Lastly, an explicitly public model of mortgage insurance would greatly aid the government's ability to engage in counter cyclical credit policies and implement macro-prudential regulation. Currently, both GSEs collect a fee for insuring mortgage loans. However, since the government isn't required to turn a profit, this fee could be adjusted to run counter to the business and credit cycle. In frothy housing markets, the fee could be increased to effectively raise the cost of mortgage financing and stop bubbles before they get started. In a depressed housing market, the fee could be reduced or even eliminated to help spur recovery. In any event, counter cyclical credit policies to smooth out the business cycle merit further attention, especially in light of the reactionary and counter-productive cutting off of traditional mortgage credit to qualified borrowers since the crisis. Such actions arguably slowed the recovery in both housing and the broader economy.
In sum, had the status quo existed before the crisis, Fannie and Freddie never would have gotten into trouble in the first place, and the government would have been better equipped to fight the ensuing recession. Furthermore, private shareholders would never have been unfairly enriched by exploiting government granted advantages. And finally, without Fannie and Freddie, the mortgage market would have completely collapsed in the wake of the crisis which would only accelerated and prolonged the downturn. I'm all for private markets and private industry, but eliminating the GSEs or reprivatizing them is just nuts.
