their skilled
workforces on securitizing residential mortgages in fair and
open competition with the private sector.
These legislative
changes would greatly reduce the risk to financial markets and
taxpayer exposure. They would also restore competition in
residential mortgage markets while leaving the housing
industry and homeownership opportunities
unaffected.
Making the Most of the
Opportunity
While Members of the
109th Congress are to be commended for taking on these two
political powerhouses, the legislative package reported out by
the House Committee on Financial Services in late May 2005 (H.R.
1461) falls short of what is needed. It will do little to address
the fundamental problems associated with these federally
supported financial monopolies that provide limited benefit to the
housing finance market or homeownership opportunities.
Notwithstanding press
reports that the new legislation would "create a new more
powerful regulator for financial services giants Fannie Mae
and Freddie Mac,"[1] some GSE reform advocates and Bush
Administration officials view it as too weak and contend that the
new regulatory system is less restrictive than the current one.[2] In
addition, the new proposal would require Fannie Mae and
Freddie Mac to use 5 percent of their profits to fund
"affordable " housing programs. This is a clumsy and costly effort
to contrive a public purpose for these enterprises, which have long
outlived any justification for the valuable privileges that they
receive from the federal government.
The failure of
Congress to address these broader issues stems from a flawed reform
process that focused on Fannie Mae's Enron-like behavior instead of
the statutory privileges that have allowed it to amass enormous
market power. Together, these two GSEs control half of the
residential mortgage market, deterring competition and forcing
the housing and housing finance markets to rely on two financially
unstable co-monopolists. With such market power concentrated in the
hands of only two companies, the stability of U.S. financial
markets could be undermined by financial problems in just one
of them. Of course, if a bailout ever becomes necessary, the
taxpayers could end up paying the bill.
In recent years, there
have been a number of proposals to reform these GSEs. Some
involve more regulation, others urge the creation of more GSEs to
foster competition among government-subsidized entities, and still
others would eliminate the statutory privileges that tie the
GSEs to the taxpayer.
New regulations have
attracted the most support, but this could turn out to be a
useless and counterproductive approach. If the GSEs provide little
or no benefit to society-beyond enriching their leaders and the
various contractors who serve them-there is little point in trying
to limit their risk with regulations and expose the taxpayers to a
costly bailout. The co-monopolists would likely survive and thrive
under a regulatory solution that would preserve the unhealthy
concentration of risk, privilege, and power in the two
companies.
Both Fannie Mae and
Freddie Mac have proven exceptionally adept at lobbying Congress to
preserve and enhance their privileges. Any effort that relies
on new regulations will likely perpetuate the risk to the financial
market and preserve their dominant influence. Indeed, if
Armando Falcon, director of the Office of Federal housing
Enterprise Oversight (OFHEO), had not courageously persisted
in exposing Fannie Mae's suspect operations, often in the face of
congressional hostility, former Fannie Mae President Franklin
Raines would still have his job and Fannie Mae's shaky finances and
fabricated earnings would still be hidden.
Instead of adopting
compromise regulations, the government should begin an orderly
process of severing all ties with the GSEs. Their most valuable
federal privileges are their $2.25 billion lines of credit (for a
total of $4.5 billion) with the U.S. Treasury and the Federal
Reserve's authority to buy their debt as part of its open market
operations. These privileges allow Fannie Mae and Freddie Mac to
claim an implicit federal guarantee of their outstanding
obligations, which in turn makes them a popular investment for many
major institutions, pension funds, and even foreign central banks.
By lowering their borrowing costs and giving them access to
subsidized credit, this implicit guarantee has allowed them to
outcompete their private-sector rivals and establish a
monopoly presence in the financial markets.
Losing Their Sense of
Purpose
Fannie Mae was created
in 1936 during the Great Depression to provide a secondary market
to encourage greater use of the innovative long-term, fixed-rate,
level-payment, fully amortized mortgages that the newly
created Federal housing Administration (FHA) was insuring against
loss of principal and interest. The exercise was a success, and
this type of innovative mortgage became the standard means of
financing the postwar housing boom that raised the homeownership
rate from 44 percent in 1940 to 69 percent by 2004.[3]
By the 1970s, the
basic purpose of the GSEs had shifted to the role of adding more
funds to the housing market by connecting prospective
homebuyers with major capital markets. To accomplish this goal, the
GSEs use their preferred credit rating to borrow in major financial
markets and use the funds raised to acquire residential mortgages
from brokers and other mortgage originators, earning profits and
covering expenses on the difference in the interest rates
earned and paid. The GSEs also package mortgages acquired from
originators into "pass through" securities that are
collateralized with qualified residential mortgages. Payments
of principal and interest made by the homeowners are then "passed
through" to the investors holding the securities.
Over much of this
period, Fannie Mae and the federal government were minor players in
the process. By 1965, the homeownership rate had risen to 63
percent, but Fannie Mae and the other sources of federal mortgage
credit support accounted for only 6 percent of outstanding
residential mortgages.[4] Savings and loan associations, savings and
commercial banks, and life insurance companies accounted for most
of the rest.[5]
Fannie Mae was
restructured as a federally chartered corporation in 1968, and
its shares were sold to the public a year later. Initially, Fannie
Mae was limited to investing in residential mortgages insured by
the FHA or guaranteed by the Veterans Administration so as to
maintain its public purpose of assisting entry-level
homebuyers.
A few years after
Fannie Mae's "privatization," Congress authorized the creation of
another government-sponsored mortgage credit facility,
Freddie Mac, as a federally chartered corporation to provide a
secondary market for the conventional mortgages written by savings
and loans and other lenders and brokers. Over time, the mandates
guiding the FNMA and FHLMC were liberalized, and the scope of their
activity was expanded substantially to the point that they and
the other federal housing finance programs now account for
more than half the residential mortgage market in the United
States.
Although structured as
private companies, both the FNMA and the FHLMC operate with
valuable federal privileges that give them a significant
competitive advantage over other participants in the housing
finance market. In particular, they are exempt from state and local
income taxes; more important, they have exclusive access to lines
of credit from the U.S. Treasury and the U.S. Federal Reserve
System. Under current law, each is permitted to borrow up to
$2.25 billion from the Treasury, and the Federal Reserve is
authorized to purchase their debt as part of any "open market
operation." Although neither of these privileges has ever been
requested, the fact that the federal government is authorized to
assist these GSEs is interpreted by investors as an implied federal
guarantee of their debt, and this interpretation allows them to
borrow at interest rates well below those paid by private companies
with the best credit ratings and only slightly higher than what the
Treasury pays on its own full faith and credit debt.
As quasi-private
companies obligated to enrich their shareholders with
ever-increasing earnings and dividends, and operating with an
implicit federal interest rate subsidy as well as a federal
mandate to promote homeownership, Fannie Mae and Freddie Mac
had every reason and opportunity to grow rapidly. By the 1980s and
early 1990s, they dominated the housing finance market. By
parlaying their subsidized borrowing advantage into lower-rate
mortgage lending, they gradually pushed life insurance companies
and commercial banks out of the less profitable residential
mortgage market and squeezed the earnings of the already wobbly
savings and loans, which by law could invest only in residential
mortgages. While homebuyers benefited from slightly lower borrowing
costs, financial markets were put at greater risk as more and
more of the housing finance system was concentrated in the hands of
two highly leveraged, unsupervised, federally chartered
financial institutions.
Concerns Met with
Public Relations
Many policymakers soon
recognized the risk to financial markets posed by such a
concentration of market share. In the late 1970s and early 1980s,
Fannie Mae made a bad bet on interest rate trends that left the
institution technically insolvent as its net worth briefly turned
negative, raising fears of a financial collapse. Fannie Mae later
recovered when the Federal Reserve's monetary policy of the early
1980s led to dramatic declines in market interest rates, restoring
the value of Fannie Mae's loan portfolio.
After implementing new
financial controls and investment practices, Fannie Mae came out of
its near-death experience as a better-managed operation.
Nonetheless, the possibility that it might fail could disrupt
financial markets in general and mortgage markets in particular.
This, in turn, led to calls to limit its size, scope, and
privileges.
In response to growing
concern and criticism, Fannie Mae adopted an aggressive public
relations program that was quickly copied by the Federal Home Loan
banks (FHLBs) and Freddie Mac, the other housing-related GSEs. With
executive pay, bonuses, expense accounts, and other top
management perks, and by promoting its stock to Wall Street
analysts, Fannie Mae presents itself to investors as a
hard-charging, profit-minded growth company.
Wall Street brokerage
firms and investment banks earn more than $100 million in fees
annually from the issuance of Fannie Mae and Freddie Mac debt
instruments and mortgage-backed securities.[6] Wall Street returns
the favor with enthusiastic endorsements of their role in the
economy and financial markets. However, when protecting itself
against the few congressional reformers and marketplace
competitors and selling its debt to foreign central banks at
favorable interest rates, Fannie Mae poses as a public-purpose
government entity that helps America's disadvantaged to become
homeowners.
As part of this effort
to garner influence, Fannie Mae has hired lobbyists by the score
and created the Fannie Mae Foundation, which over the past five
years has pumped $500 million into highly visible and heavily
promoted local projects and grants.[7] In the process of spreading
its message, every interest group is cultivated.
Even America's college
professors became objects of Fannie Mae's affection when it created
and financed two academic journals-housing Policy
Debate and Journal of housing Research-that focus (with
a notable exception) on a wide range of housing issues. The
exception is that both journals generally avoid discussing the
GSEs' role in the mortgage market and whether they make much of a
difference. With many professors still confronting a
publish-or-perish environment in pursuit of tenure and
promotion, common sense argues against irritating a wealthy and
influential publisher. As a result, academia has not been a
reliable source of dispassionate inquiry into the GSEs' role in
America's housing market.
Is Fannie Mae Really
Needed?
However, independent
analysts have looked into the matter and have found little evidence
that the FNMA, FMLMC, and FHLB make much of a difference in
how many new homes are built or how many Americans become
homeowners. In fact, a broad review of the evidence accumulated in
the postwar era suggests that their impact on homeownership is
inconsequential.
Specifically, in 1965,
when the GSE presence in the mortgage market was slightly above 6
percent, America's homeownership rate was 63.3 percent. In 1990,
after outstanding residential mortgage credit had expanded more
than tenfold from $220.8 billion in 1965 to $2.6 trillion in 1990
and after the federal and GSE presence in the residential mortgage
market had grown from 6 percent in 1965 to 48 percent in 1990,
America's homeownership rate was at 63.9 percent-virtually
identical to the rate 25 years earlier. Expressed another way, the
$1.24 trillion increase in federal and GSE involvement in the
mortgage market was associated with an increase of less than 0.6
percentage points in the homeownership rate.[8]
In this regard, it is
worth noting that America's greatest surge in homeownership took
place between 1946 and 1960, when homeownership jumped from the
mid-40 percent range at the end of World War II to 62 percent in
1960, when the FNMA's activity was still limited and the FHLMC did
not yet exist.
From 1990 to 2003, GSE
involvement in outstanding mortgage credit expanded
substantially, from $1.0 trillion in mortgages in 1990 to $3.4
trillion in 2003. During the same 13 years, total
outstanding residential mortgage loans increased almost
threefold, from $2.6 trillion to $7.3 trillion,[9] and
the homeownership rate increased from almost 64 percent in 1990 to
68 percent in 2003.
However, this does not
mean the GSEs finally made a difference. credit instead goes to the
Federal Reserve's anti-inflation, pro-growth monetary
policies, which drove down the AAA corporate bond rate from 9.32
percent in 1990 to 5.67 percent in 2003 and the home mortgage
rate from 10.05 percent in 1990 to 5.80 percent in 2003. With the
mortgage rate falling to half of its peak level, housing demand
soared as monthly mortgage payments fell accordingly. housing
markets in the 1990s also benefited from the significant rise in
employment and incomes over the decade, which allowed more families
to accumulate the money for a down payment and qualify for a
mortgage. As a consequence of these favorable macroeconomic
developments, homeownership rose to record levels, independent
of anything Fannie Mae and Freddie Mac did over the same
period.
While these anecdotes
are less than perfect proof of FNMA ineffectiveness, more
comprehensive studies by the Federal Reserve Board and the
Congressional Budget Office have come to similar
conclusions. In 2003, Wayne Passmore, a Federal Reserve
economist, wrote that "the GSE's implicit subsidy does not appear
to have substantially increased home-ownership or homebuilding" and
argued that the GSE's activity slightly lowered mortgage rates for
some homeowners.[10] More recently, an article in the
prestigious Journal of Economic Perspectives contends
that "it does not appear that the companies' activities have
appreciably affected the rate of homeownership in the United
States" and cites several other studies that support that view.[11]
One reason for the
tenuous connection between a general increase in mortgage
credit and increased homeownership is that beyond some point, an
increase in mortgage credit availability mostly makes itself felt
in higher loan-to-value ratios (lower down payments), higher home
prices, and/ or a diversion of mortgage credit to non-housing
investments. As the early postwar record indicates, existing
private credit markets were perfectly capable of driving the
homeownership rate into the mid-60 percent range. However, as more
credit is forced into the system through the creation and expansion
of subsidized GSEs, mortgage interest rates may fall somewhat, but
this encourages private financial institutions that provide
housing credit to look elsewhere for investments with better
yields. While the slightly lower interest rates encourage and/or
allow some moderate-income borrowers on the margin of eligibility
to become homeowners, this stimulative effect may be partly or
wholly offset by a credit-induced rise in home prices in excess of
the growth in personal incomes.
While finding ways to
assist the marginal buyer to become a homeowner has been one of the
federal government's important public policy goals for much of
the postwar era, relying on the GSEs to help achieve that goal is
not an effective way to boost homeownership. As currently
configured, the GSEs do not target the loans of marginal buyers but
rather provide secondary market support to qualifying or conforming
mortgages, most of which are secured by property owned by
middle-income and higher-income households that are capable of
buying and borrowing without federally sponsored
support.
Despite its claims to
the contrary, Fannie Mae's basic operating procedures do not target
any particular type of buyer/borrower. Indeed, evidence from
the federal government indicates that Fannie Mae and Freddie Mac
are in fact neglecting first-time homebuyers in comparison to the
entire private conventional mortgage market. Between 1999 and 2003,
9.0 percent of the conventional conforming loans (the type the GSEs
are authorized to buy) made by the private mortgage market were to
first-time minority homebuyers. By contrast, only 4.7 percent of
Fannie Mae loans and 3.5 percent of Freddie Mac loans over the same
period were to first-time minority homebuyers.[12]
Although one could
give Fannie Mae the benefit of the doubt and view this failing as
simply one of neglect, other actions by Fannie Mae in late 2004 and
early 2005 suggest both that the neglect may be willful and that it
reflects the company's bias against prospective lower-income,
entry-level homebuyers. In January 2005, coalitions of low-income
housing advocacy groups[13] published reports that challenged
the value of policies promoting and encouraging homeownership
among poor and moderate-income neighborhoods, arguing that
homeowner "benefits may have been overstated" and that
"rentals, public housing and other options may make better
economic sense."[14] Although these organizations had
previously published a number of papers and reports expressing
skepticism about the value of homeownership, the two most recent
reports, published in January 2005, were funded by the Fannie Mae
Foundation.[15]
Suspiciously, the
release of these anti-homeownership reports by the Fannie
Mae-assisted advocacy groups was followed one month later by the
release of a new rule from the Department of Housing and Urban
Development (HUD) requiring Fannie Mae and Freddie Mac to improve
mortgage availability to minority and moderate-income-buyers. In
effect, while Fannie Mae was conducting a massive and costly public
relations campaign to present itself as the benefactor of
moderate-income and minority homebuyers, it was funding studies
that undermined that very goal. In a town awash with
insincerity, the ambidexterity of Fannie Mae's principles is
in a class by itself.
As for the GSEs'
ultimate value, competitive improvements in the residential
mortgage market have further undermined the connection between
mortgage credit and homeownership as the availability of
second mortgages on attractive terms and the refinancing of
existing first mortgages, combined with the provisions of
federal tax law, have encouraged the redirection of mortgage credit
to non-real estate purchases. With mortgage interest payments still
deductible from income for state and federal tax purposes, more and
more households use mortgage credit obtained through a mortgage
refinancing to buy a car, conduct home improvements,
consolidate personal debt, or pay for a college education
because the interest payment that would otherwise be incurred on
debt accumulated directly for these reasons-such as a car
loan from a dealer or a student loan from a bank-is not
tax-deductible. In part, this privileged use of debt, combined with
substantial home price inflation, explains why outstanding
residential mortgage credit has nearly tripled since 1990 while
housing production and homeownership have expanded at a much slower
pace.
Understanding the Real
Problem
With little compelling
evidence to indicate that four and a half decades of intrusive GSE
activity has made much of a difference in homeownership rates,
housing production, or helping the marginal buyer to become a
homeowner, one has to wonder whether the costs and risks associated
with these enterprises are justified.
Regrettably, from the
extensive discussions, hearings, proposals, and
counterproposals, it appears that Congress and the White House gave
little thought to asking whether these entities should exist in the
first place or why these for-profit entities should continue to
enjoy the extraordinary federal privileges that allow them to
maintain their monopoly status at the potential expense of the
taxpayers.
The evidence reveals
that Fannie Mae's management team appears to be the chief
beneficiary of the federal privileges and the accounting
irregularities that were recently uncovered. For example, in 2003,
749 members of Fannie Mae's management team received a staggering
$65.1 million in bonuses, a portion of which was attributable to
the overstated earnings that followed from the accounting
irregularities.[16] Over the past five years, the top 20
Fannie Mae executives reportedly received combined bonuses of
$245 million.[17] This disconnect between reward and
mission suggests that any reconciliation with the Securities
and Exchange Commission should also require that the FNMA's
management return their bonuses to a fund administered by a
bona fide not-for-profit entity, such as Habitat for
Humanity, for the purpose of assisting prospective homebuyers of
modest means.
Although management's
unearned bonuses have generated most of the headlines, the real
cost to the nation is not the tawdry looting of the company by its
top management team. The real problem is the concentration of risk
in the hands of two massive and privileged companies that now
dominate America's housing finance markets.
Ironically, Fannie
Mae's management has attempted to use the prospect of such risk to
protect itself from better government oversight. In response
to the U.S. Treasury's effort to improve oversight, former FNMA
President Frank Raines admitted in a letter to U.S. Treasury
Secretary John Snow that financial market instability could occur
if even the slightest concern about the FNMA's operations were
openly discussed: "From the beginning of our discussions, you and I
have agreed to avoid disrupting the capital markets by indicating a
wish to change Fannie Mae's charter, status, or mission."[18]
Lest one think that
such an occurrence would be a distant possibility, the record
reveals that federally sponsored financial institutions, including
those that the federal government closely regulates and insures,
have a knack of frequently exploding in hugely horrific and costly
ways. Since the mid-1980s, massive losses have occurred in the
federal Farm credit System, the Federal Deposit Insurance
Corporation, and the Federal Savings and Loan Insurance
Corporation. Worse, the heavily regulated and supposedly
closely supervised savings and loan industry collapsed more than a
decade ago, and repairing the residual damage cost the U.S.
taxpayers $130 billion.
What Should Be
Done
Ideas have
consequences, as the saying goes, but the process is seldom
instantaneous. In June 1990, echoing earlier HUD recommendations, a
Heritage Foundation research fellow recommended that Fannie Mae
"[c]ease payment of dividends to shareholders, so that all
earnings can be applied to reserve accumulation."[19] In January 2005,
nearly a decade and a half later, amidst the worst financial
scandal in the company's history, Fannie Mae announced that it
would cut its dividend in half.
To date, the Bush
Administration, through the leadership at the U.S. Treasury and
OFHEO, has done an excellent job of exposing the corruption in the
GSEs and setting in motion an effective process of improvement. In
both the FHLMC and the FNMA, problematic leadership has been forced
to resign and the companies' boards of directors have been required
to make overdue changes in corporate governance. The January
2005 FNMA agreement to cut its dividend to build reserves will
add stability to the system.
But much more needs to
be done, and most of the responsibility will fall on Congress
because the laws governing the GSEs are flawed and need to be
changed. The proposals endorsed by the House Committee on Financial
Services do not go nearly far enough, and the White House has
expressed concern with the timid reform package under
consideration.
Enhanced regulations
have attracted the most support, and the House Committee on
Financial Services has proposed changes in how the GSEs are
regulated, but a regulatory approach to GSE problems could
easily become useless and counterproductive. With substantial
evidence suggesting that the GSEs provide little or no benefit to
society, trying to prop them up with new regulations makes
little sense. The latest congressional strategy essentially
compels taxpayers to bear the risk of a new regulatory regime that
would perpetuate the commanding market position of these
ineffective co-monopolists.
However, the greater
risk is not that additional regulation of the GSEs will render them
merely useless, but that it will render them both useless and
dangerous. As past practices reveal, it is likely that Fannie Mae
and Freddie Mac will soon co-opt the regulators as they have done
so adeptly in the past. The Fannie Mae Foundation's $500 million of
goodwill spending will buy the company helpful and influential
supporters by the trainload. One merely needs to read the
transcript of a recent congressional hearing for a sense of
the loyal following that Fannie Mae has assembled in Congress.[20]
To correct the
situation, Congress should:
Conclusion
Congress has an
opportunity to reduce financial market risk and taxpayer exposure
and to restore competition in the residential mortgage market. At
the same time, the housing industry and homeownership
opportunity will remain unaffected.
Ronald D. Utt,
Ph.D., is Herbert and Joyce Morgan Senior
Research Fellow in the Thomas A. Roe Institute for Economic
Policy Studies at The Heritage Foundation.