It's the Wrong Time to Curb Freddie and Fannie
In the wake of the savings and loan bailout, Congress has become troubled by the risks that the Federal Home Loan Mortgage Corp. and the Federal National Mortgage Association pose to taxpayers.
These federal mortgage conduits issue debt whose government guarantees, like the one underlying federal deposit insurance, create contingent liabilities of the federal government.
The fear is that Freddie's and Fannie's contingent liabilities, like those of the bankrupt federal insurer of thrift deposits, will become the real liabilities of current and future taxpayers.
The Thrifts' Complaint
Several large thrifts have raised the claim that Freddie and Fannie enjoy an unfair implicit federal subsidy. Because these entities can raise capital to buy mortgages through the issuance of government agency-grade debt, goes the argument, thrifts are at a disadvantage when competing for mortgages to be held in portfolio.
Proponents of these arguments are mounting a campaign to rein in the federal mortgage conduits. However, both lines of reasoning are seriously flawed. Moreover, given the short- to medium-term outlook for the residential mortgage markets, there is a strong justification for supporting the activities of the two entities.
Congress' concern about Freddie's and Fannie's contingent liabilities is misplaced, because the regulatory incentives facing Freddie and Fannie are far different from those that precipitated the thrift debacle.
In 1981, the Federal Home Loan Bank Board (the thrift industry's government regulator) knew that the industry was broke in real terms, and also that the Federal Savings and Loan Insurance Corp. (FSLIC) did not have enough capital to liquidate those thrifts that had already failed.
Desperate to prevent the FSLIC's insolvency, the Board created a series of net worth and accounting forbearances to encourage the industry to grow out of its problems.
These incentives encouraged rapid growth during the mid-1980s, and perhaps would have succeeded in rescuing many thrifts had there not been a confluence of adverse events: the implosion of real estate prices following the 1986 Tax Act, the collapse of several regional economies and most recently, re-regulation mandated in the Financial Institutions Reform, Recovery, and Enforcement Act.
In contrast to this scenario, Freddie and Fannie are solvent and profitable. Moreover, they operate in a regulatory environment that differs substantially from that which led to the thrift debacle: both entities' charters restrict them to investing in and guaranteeing residential mortgages exclusively.
Moreover, their federal overseers have not provided them with incentives for excessive growth. Consequently, the level of taxpayer risk exposure associated with Freddie's and Fannie's contingent liabilities is significantly lower than that associated with FSLIC in the 1980s.
In fact, the legacy of the thrift bailout has itself created a strong public policy justification for supporting the activities of Freddie and Fannie. The guarantee functions of both will be crucial for maintaining an adequate supply of residential mortgages in the medium term, when banks and thrifts will be unwilling to lend freely as they (continue to) adjust to the more rigid post-FIRREA regulation.
This new environment includes increased regulatory scrutiny of bank and thrift real estate loan portfolios as well as higher capital requirements for all but the strongest thrifts.
According to a study that we did last fall using data from June 1990, almost one third of private-sector thrifts would not have been able to meet the new requirements at that time; fewer than half were even profitable. However, the capital-deficient thrifts held over half of the industry's assets.
According to our estimates, the thrift industry will have to sell at least an additional $100 billion of mortgages to satisfy the new requirements. The resulting shrinkage will take place during a decade when 12 million new households are expected to be formed.
Indeed, the current shortage of funds has already resulted in a severe slowdown in the construction of apartment buildings and of homes within reach of the first-time buyer. Given this bleak scenario, a decision to restrict the asset powers of Freddie and Fannie would be contrary to sound public policy.
The other argument for reining in Freddie and Fannie involves the implicit subsidy that they receive from being able to sell debt of federal agency grade. Several large thrifts, which must sell more expensive debt of private issuer grade, have argued that Freddie and Fannie should pay user fees to create a level playing field.
Funding by Way of Agency
Absent from this point of view is the fact that thrifts enjoy important borrowing privileges from the Federal Home Loan Bank System, a mixed-ownership public corporation that borrows in the credit markets at rates more favorable than those enjoyed by Freddie Mac and Fannie Mae and then relends to member thrifts at slightly higher rates. Additionally, the FHLB System pays dividends, whose annual yields were as high as 8% in 1990, to member thrifts.
Large thrifts find this source of funding to be very attractive: as of June 1990, almost half of the FHLB System's advances were held by 14 thrifts, of which ten are in California. Thus, a significant amount of federally subsidized borrowing supports the mortgage portfolios of privately owned thrifts.
Ultimately, the debate about the dominance of Freddie and Fannie in the mortgage markets is really a debate about the efficient allocation of assets, in this case mortgages. In the current system, initiated by Congress in the 1930s, thrifts were intended to play a key role as originators and portfolio holders of mortgage assets.
The initial objective of this system was to replace the short-term, unamortized mortgages then available to home buyers with long-term, fully-amortized mortgages. The provision of these more favorable mortgages, it was hoped, would promote stability during cyclical economic downturns and achieve the public policy goal of an increased national rate of home ownership.
Thrifts successfully played their intended role as lenders and portfolio holders of residential mortgages until the late 1970s, when roller-coaster interest rates, compounded in 1986 by tax code changes, undermined the profitability for them of holding mortgages.
During the same period, mortgage securitization by the federal mortgage conduits began to account for an increasingly larger share of residential mortgage holdings, a trend that continued into the 1980s.
The guarantees of the federal conduits have made investment in mortgage-backed securities an attractive alternative to investment-grade corporate bonds for institutional investors like pension funds and life insurance companies.
In addition, there now also exist mutual funds specializing in Freddie and Fannie securities, backed by flxed-and adjustable-rate mortgages, which allow individuals effectively to act as portfolio holders.
This evolution of the mortgage delivery system has increased its efficiency, and the ultimate winners are mortgage borrowers.
The decline in thrifts' importance as mortgage holders does not mean that the industry can no longer be a useful part of the mortgage delivery system. Some of the most profitable and best-capitalized thrifts are really mortgage banks - thrifts that originate mortgages primarily for sale in the secondary market. Embracing mortgage banking, rather than fighting the declining profitability of portfolio lending, is probably the best course for most thrifts right now.
The issue of unfair competition from Freddie and Fannie really misses the point. The natural evolution of the mortgage market has made portfolio lending unprofitable for thrifts. Freddie and Fannie have merely fulfilled a legitimate aim of government by accelerating the pace of a change that benefits a broad segment of society.
Where the government has erred is in restricting the scope of assets that thrifts can hold to being virtually the same as those held by the federal mortgage conduits; these restrictions are what will make thrifts the buggy whip of residential finance.
There is no valid reason for these restrictions. Liberalizing the kinds of assets that thrifts can hold will make them viable, useful elements in the nation's mortgage delivery system in a way that reining in Freddie and Fannie cannot.
Charlotte Chamberlain is a vice president and Bennet Zelner a research analyst with National Economic Research Associates, a private economic consulting firm.