Cracks in the Fannie-Freddie foundation
From the April 13, 2001 print edition
Critics charge Fannie Mae, Freddie Mac pose risk to economy
Eric Winig Staff Reporter
Remember the old ads for Sara Lee? They ended with the catchy little jingle "Nobody doesn't like Sara Lee."
Replace Sara Lee with "Fannie Mae" and who would argue? Fannie Mae is widely considered as American as
motherhood and apple pie, with an unassailable mission to provide homeownership to those who otherwise
couldn't afford it.
Fannie itself does much to promote this image, pouring millions into advertising and, perhaps more importantly,
sponsoring countless events for U.S. congressional candidates.
For example, Fannie Mae sponsored a luncheon and roundtable discussion with U.S. Rep. Connie Morella,
R-Md., Feb. 26 at the Bethesda Hyatt. The firm also regularly holds events for members of the House
Subcommittee on Capital Markets, Insurance and Government-sponsored Enterprises -- the committee charged
with keeping tabs on Fannie Mae (http://www.fanniemae.com).
This is clearly a company for which impressions count.
But impressions can be misleading.
A growing contingent of critics -- from scholars at the conservative American Enterprise Institute to
über-liberal Ralph Nader -- contends Fannie Mae and its sister organization, Freddie Mac, have outgrown their
usefulness. They charge that the government subsidies these government-sponsored enterprises (GSEs)
receive -- estimated by the Congressional Budget Office at $6.5 billion a year -- often wind up not in the
pockets of prospective home buyers, but in the coffers of Fannie, Freddie and their shareholders.
More ominously, some say the two housing GSEs have grown so large and taken on so much risk that they
pose a systemic risk to the entire U.S. economy, akin to the savings and loan debacle of a decade ago.
Indeed, as Fannie and Freddie strive for the high-octane growth craved by Wall Street, they are increasingly
turning to risky areas such as subprime and home-equity loans, thus ratcheting up their risk and increasing the
odds of a costly taxpayer bailout.
Fannie and Freddie execs dismiss such talk as alarmist and inaccurate, and contend they are two of the
best-managed, safest institutions in the world. Furthermore, they say the U.S. housing system, widely
considered the best in the world, depends on their activities for its continued strength.
The controversy has attracted the attention of Congress, specifically Rep. Richard Baker, R-La., chairman of
the Capital Markets Subcommittee. Baker, who roiled markets last year when he questioned the role of the
GSEs, recently introduced legislation to tighten the regulatory structure around the two mortgage giants.
Fannie and Freddie have vowed to fight the bill, setting the stage for yet another battle in a saga that ultimately
involves billions of dollars, taxpayer trust and the potential for financial catastrophe.
If the bubble bursts
"These institutions will collapse."
This blunt assessment comes from Doug Noland, an analyst at David Tice & Associates, a Dallas-based
money management and research firm (http://www.tice. com). Noland, who has been a vocal critic of the
GSEs for years, says Fannie and Freddie (http://www.freddiemac. com) increasingly have become the buyer of
last resort for financial markets and have grown so large and unwieldy that a large-scale bailout is all but
unavoidable.
The logic behind his argument is that Fannie and Freddie, through their aggressive lending tactics, have created
a real estate bubble of historic proportions. Consumers have leveraged themselves to the hilt against their
houses on the assumption that prices will continue to go up.
However, as the harrowing tale of the Nasdaq has shown, bubbles don't last forever. When this one finally
bursts, Noland says, we will have "one hell of a mess" on our hands.
He backs up his contentions with these statistics:
Over the past three years, the GSEs have expanded their holdings of financial assets by more than $870
billion.
Fannie Mae has a total book of business of more than $1.3 trillion, and an "allowance for losses" account of
$809 million. This equals $6 held in reserve for every $10,000 worth of exposure.
Consumers, too, are more stretched than ever. While home prices are at an all-time high, home-equity
ownership is at an all-time low. Americans now own less than 55 percent of the equity in their homes, versus
almost 70 percent in 1982. In other words, people are pulling money out of their homes even faster than the
rapid rate at which prices have been appreciating.
And, ominously, as the economy slows, the number of people falling behind on their mortgages is beginning to
rise. The Mortgage Bankers Association reports delinquencies on single-family homes rose in the fourth
quarter of 2000 to 4.54 percent. That compares with 3.82 in the fourth quarter of 1999, and the number is
expected to keep rising.
"The trend is definitely up," says Doug Duncan, chief economist at the MBA (http://www.mbaa.org).
Another bailout?
Noland is not alone in his criticisms of the GSEs. A number of independent think tanks -- including the
American Enterprise Institute (AEI), the CATO Institute, the Heritage Foundation and the Competitive
Enterprise Institute (CEI) -- recently have published papers that strongly favor changing the current system.
The problem is this: Financial markets view Fannie and Freddie as implicitly backed by the government because
of their link to the Treasury Department, which enables them to borrow money in virtually unlimited quantities
at lower interest rates than any other corporation.
If the markets ever were to lose faith in the two organizations, however, it could set off a panic to get out of
their bonds. Because these securities are held in huge quantities by all manner of banks and investment firms,
this could precipitate a crisis on the scale of the Long-Term Capital Management implosion in the fall of 1998.
LTCM, a heavily leveraged hedge fund, caused a worldwide crisis when it came to the brink of insolvency.
Investors, knowing the fund was in trouble, dumped any securities they believed to be at risk, creating a vicious
cycle of selling.
While the government did not commit any of its own money to rescue the fund, the Federal Reserve Bank of
New York did step in to organize a $3.65 billion bailout from a 14-bank consortium.
At its peak, LTCM controlled contracts worth roughly $160 billion. Considering the huge amount of debt that
Fannie and Freddie have outstanding-- currently $1.07 trillion -- a similar event involving the GSEs could cause
markets to freeze up and essentially stop functioning. Huge financial institutions would almost certainly face
insolvency, as they would be forced to mark down bonds they previously had considered to be virtually
risk-free.
Were such an event to occur, it is almost unthinkable that the federal government would let Fannie and Freddie
fail, as it could endanger the entire global financial architecture. The government in fact has a history -- with
LTCM being just the latest example -- of bailing out institutions considered "too big to fail."
The potential result? Yet another taxpayer bailout of a big institution and its wealthy investors and executives.
In essence, Fannie and Freddie's link to Treasury -- which gives the Treasury the right, but not the obligation, to
purchase up to $2.25 billion in debt each from Fannie and Freddie -- encourages them to take unusually large
risks in order to generate additional returns. (The Treasury has never exercised the option, and the relationship
is viewed by financial markets as strictly symbolic that the U.S. government will stand behind the two GSEs if
and when the need arises.)
While such a strategy benefits mostly the firms' executives and shareholders because of greatly enhanced
profits, the risks of these actions are borne almost entirely by taxpayers. If the organizations ever falter, the
government simply will transfer money from taxpayers to Fannie and Freddie, under the guise of saving the
world.
"It's the classic case of moral hazard," says Peter Wallison, resident fellow at AEI and co-author of
Nationalizing Mortgage Risk, an AEI study on the potential problems posed by Fannie and Freddie.
This study found:
Fannie and Freddie increasingly dominate conventional/conforming mortgages -- loans under $275,000 -- and
soon will control more than 90 percent of this market.
Fannie and Freddie no longer are necessary to serve their original purpose -- providing liquidity for secondary
mortgage markets. These days, financial markets are more than capable of securitizing
conventional/conforming mortgages.
The lower mortgage rates touted by Fannie and Freddie actually may benefit home sellers and developers
rather than home buyers by inadvertently contributing to housing inflation.
As Fannie and Freddie grow bigger and more powerful, it will become increasingly difficult to avoid a
catastrophic result, simply because the two hold such a huge amount of risk concentrated in a single area.
Stress tests
GSE executives say the fear of such a blowup is overblown, and point to stress tests that show the two
organizations could withstand extremely severe economic conditions.
Fannie Mae Chief Financial Officer J. Timothy Howard, testifying before a House subcommittee March 27,
said the firm "could endure the worst economic shocks in history -- shocks that few other financial institutions
could survive -- with significant capital left over."
For example, the two firms have modeled the impact of an immediate 5 percent decline in housing prices
nationwide. Yet such tests are, by design, based on past experience and have no way of predicting what
stresses might occur in the future.
"The whole issue of stress has not been thoroughly examined," says Bert Ely, an Alexandria-based financial
services consultant and co-author of the AEI study (http://www.aei.org).
LTCM, for example, had incredibly complex computer models -- put together by Nobel laureates Robert
Merton and Myron Scholes -- that showed the firm never would lose more than $35 million in a single day. Yet
on Friday, Aug. 21, 1998, LTCM lost a staggering $553 million.
The problem is that markets, especially under very stressful conditions, often fail to act in the smooth,
continuous manner predicted by computer models.
Fannie and Freddie officials seek to reassure investors by citing the elaborate hedges they use to protect
against unforeseen circumstances. In fact, Fannie Mae Chairman and CEO Frank Raines says his firm will not
take on additional business, or the risk it entails, if it can't find appropriate counter-parties.
"We will not do the business without finding people with whom to share the risk," he says.
Fannie Mae uses a variety of counter-parties -- specifically mortgage insurers -- to hedge against the potential
for catastrophic loss. Mortgage insurers provide private mortgage insurance, which Fannie and Freddie require
for mortgages of more than 80 percent of the home value.
Fannie Mae's Howard, in his recent testimony, said if housing prices suddenly were to decline by 5 percent,
Fannie Mae would suffer a gross credit loss of $1.065 billion. However, he added that credit enhancements, or
hedges, would absorb $770 million of this loss, resulting in a net loss to the company of only $295 million.
While that sounds good, it is certainly possible that such a huge, unexpected drop in equity values would result
in additional damage to the U.S. financial system. Under such conditions, Fannie's risk-sharing partners might
not be in a position to make good on their insurance contracts.
"Most models aren't structured for those types of extremes," says Charles Peabody, a bank analyst with
Mitchell Securities in New York. "You can't hedge discontinuous markets."
Attacks by competitors
While Fannie and Freddie executives insist there is nothing to worry about, others are not so sanguine. A
survey in August by the National Association for Business Economics -- which boasts Federal Reserve
Chairman Alan Greenspan as a former president-- shows growing concern about the two GSEs.
The survey reveals that 60 percent of the group's members -- 3,000 individuals representing more than 1,500
businesses and other organizations from around the world -- feel there are risks to continuing subsidies to the
GSEs. A full 38 percent believe the subsidies should be eliminated entirely, while 28 percent wish to curtail
Fannie and Freddie's expansion into new markets such as subprime and home-equity lending.
In addition, the aforementioned think tanks all have taken a stand in recently published papers that Fannie and
Freddie, as currently structured, pose a systemic threat to the nation's -- and indeed the world's -- financial
markets.
CEI, for example, titled a recent paper "Fannie and Freddie: Fiscal Frauds," while AEI -- in its Nationalizing
Mortgage Risk study -- says the two "are fast becoming a problem that can no longer be ignored."
The GSEs respond to such criticism by pointing to corporate sponsorship of think tanks, the implication being
that large donors -- such as big money banks -- are, in effect, sponsoring studies sympathetic to their views.
Fannie and Freddie contend these papers, rather than being objective observations, simply are veiled attacks
from competitors concerned about losing market share.
In at least one case, the point can't be ignored. The Cato Institute (http://www.cato.org) has received donations
from a laundry list of financial giants including Chase, Citigroup, Fidelity Investments, American Express and
Charles Schwab.
Whether the point is salient across the board is tough to determine. AEI, the Heritage Foundation and CEI do
not disclose their corporate donors.
A questionable existence
Whether or not Fannie and Freddie pose a true threat to the world's financial system, some argue there is
another reason to crack down on the two housing GSEs.
"There is absolutely no reason for them to exist," says Fred Smith, president of the D.C.-based Competitive
Enterprise Institute (http://www.cei.org).
The argument put forth by Smith and others is that the financial markets today are perfectly capable of doing
everything that Fannie and Freddie do. Even better, they can do it without an implied government guarantee.
Because of the GSEs' favored status with debt markets, however, other providers slowly are being squeezed
out of the market.
The GSEs are "competing with other organizations that don't have their advantages," says AEI's Wallison. He
and Ely project that, based on Fannie and Freddie's publicly stated growth goals, the two firms will own or have
guaranteed 91.5 percent of all conventional/conforming mortgages by 2003.
The GSEs originally were created to increase liquidity in the mortgage market, specifically by packaging
mortgages into mortgage-backed securities. Back in 1938, when Fannie Mae was created, this was truly a
unique service. Today, however, Wall Street firms have mastered the art of securitization, with everything from
credit card receivables to auto loans being packaged and sold off in chunks to investors.
Critics of Fannie and Freddie question why the government should continue to subsidize these institutions when
it seems the rest of the market easily could pick up the slack.
"The mortgage markets no longer need Fannie and Freddie," Wallison says.
Fannie Mae officials dispute this, saying the service Fannie provides is something Wall Street has yet to offer.
"We [take] what we call the unruly cash flows from consumers and turn them into more predictable cash flows
for investors," Fannie Mae's Raines says. "So far, there's no evidence of a Wall Street mechanism that can do
that.
"This is a very valuable process. In other countries, they don't have that, and that's why they don't have
30-year, fixed-rate mortgages."
But there are markets in which Fannie and Freddie do not participate -- such as the jumbo mortgage market in
this country -- where consumers still are able to obtain 30-year, fixed rate mortgages. That weakens the claim
that other countries' lack of such mortgages is due to the fact that Fannie and Freddie do not operate there.
Raines concedes the point, but argues that conventional mortgage rates would be forced significantly higher --
possibly by 100 to 125 basis points -- if Fannie and Freddie were taken out of the picture.
Even if this were the case -- a point which is hotly debated among industry observers -- it is different from the
claim that Fannie and Freddie provide a service not offered anywhere else.
It is possible that Fannie and Freddie, because of their ability to borrow money at below-market rates, do
indeed serve to lower mortgage rates. But the question becomes: Is this an effective use of taxpayer money?
Some say no.
According to Wallison and Ely's report, "Economists believe that the lower rates attributable to the GSEs'
subsidized borrowing are simply capitalized into the cost of the homes, thus benefiting developers and home
sellers rather than buyers."
If true, this means taxpayer money essentially is serving to jack up home prices throughout the country.
Therefore, while home buyers may in fact receive a lower mortgage rate, they will wind up with the same
monthly payment because they are paying more for the house.
"If the intent is to subsidize homeowners," says a staffer at the Federal Reserve, "this is truly a roundabout way
to do it."
Money creators?
Some take the argument a step further, contending that Fannie and Freddie have created a real estate bubble
that dwarfs the recently ended Nasdaq mania. In fact, there is a small but vocal group that says the two
housing GSEs are, by their actions in the housing market, actually creating money.
In other words, when the GSEs borrow money from the money markets and lend it to banks, they cause the
amount of money in circulation to increase.
"There is a perception that only banks create money," Noland says, "but the GSEs create money, too."
In simple terms, Fannie and Freddie create money by borrowing from the money markets, which are willing to
lend virtually unlimited amounts to the GSEs. This money is used to purchase mortgages or mortgage-backed
securities from banks, which, in turn, have a real incentive to get the cash off their books and into new loans.
Once the money is lent -- presto! -- new money has entered the system.
Fannie and Freddie strongly deny this, arguing they simply are buying -- or guaranteeing -- mortgages that
already exist.
"We don't create debt," says Ed Golding, senior vice president for financial research at Freddie Mac.
But others don't see it this way, and argue the GSEs use their favored status to pump new cash into the
system.
"Fannie and Freddie have the ability to print money," says Michael Shamosh, senior fixed-income strategist with
Boston-based securities firm Tucker Anthony (http://wwwtuckeranthony.com). Shamosh says all this extra
cash sloshing around creates distortions in the market, no matter where it comes from.
"It doesn't really make a difference how the money gets into the banking system," he says.
In fact, because banks' results are so closely tied to leverage ratios, any institution that does not lend the
additional funds in a timely manner risks dragging down its own returns. The more money a bank is able to
lend, the more juicy interest payments flow to its bottom line. Extra cash sitting on the books doesn't do much
for profits.
The sub debt assumption
Perhaps the most troubling aspect of Fannie and Freddie has to do with their belief that they can take a risky
asset -- mortgage debt -- and turn it into a virtually risk-free one -- GSE debt. There have been many times in
the past that financiers thought they had figured out how to turn risky assets into nonrisky ones. None has had
a happy ending.
Long-Term Capital Management, for example, thought it had devised a method under which it would provide
blowout returns with decreased risk. The model was even more compelling because it was devised by some of
the smartest minds in finance. The reality turned out to be far different from the computer model.
Fannie and Freddie say investors buy their debt because the firms are extremely well-managed and provide an
attractive investment opportunity. But others say investors simply are banking on the implied guarantee that the
government will stand behind the two institutions.
Hoping to settle the issue, Fannie and Freddie recently began issuing subordinated debt, which would
specifically not be backed by the government.
Sub debt, as it is called, is subordinated to a firm's senior debt, which means that sub debt holders are less likely
to get paid back in the event of a default.
The firms' senior debt also states that it is not backed by the government, but with the sub debt there is no
guarantee at all -- implicit or otherwise.
Standard & Poor's recently rated Fannie Mae's sub debt at AA-, an extremely high rating. "There's only a
handful of financial institutions that have an equal rating," Raines says.
However, while S&P did not assume that the government would stand behind the sub debt when assigning its
rating, it operated under the assumption that all of Fannie's other advantages would stay in place, according to
S&P analyst Michael DeStefano. In other words, S&P assumed that even under stressful conditions, Fannie
Mae still would be able to issue senior debt on advantageous terms. Clearly, S&P's rating of Fannie Mae was
influenced by this, although DeStefano will not say how big a factor it played.
So the controversy continues.
'A stabilizing force'
In 1998, when financial markets came within inches of melting down, Fannie Mae and Freddie Mac reportedly
took heroic steps to keep the system liquid.
In October 1998, Fannie Mae committed to purchase $30 billion worth of mortgage loans and securities and
issued $12.5 billion in long-term debt.
These actions provided desperately needed cash to highly leveraged financial institutions, most of which were
unable to raise cash because of the global credit crunch. Fannie and Freddie, in turn, benefited from investors
who sold risky assets and sought only the safest financial instruments -- Treasury and GSE debt.
Fannie Mae's Howard, in his House testimony, told committee members that, in such situations, Fannie Mae
"can act as a stabilizing force for the whole system."
Yet such a statement raises some thorny issues for Fannie and Freddie. To wit, do the GSEs have any business
trying to stabilize financial markets?
"That isn't the way the system is supposed to work," says AEI's Wallison.
The problem, again, is this: If financial market players expect to be bailed out in times of stress by the GSEs --
or anyone else, for that matter -- they will take on more risk than they otherwise would.
Some contend that the bailout of the markets in late 1998 -- whether by th |
