Those who don't study history.....

From Commentary Magazine, November, 2008

The Madness of Crowds

John Steele Gordon From issue: November 2008

Fueled by easy credit, the real-estate market had been rising swiftly for some years. Members of Congress were determined to assure the continuation of that easy credit. Suddenly, the party came to a devastating halt. Defaults multiplied, banks began to fail. Soon the economic troubles spread beyond real estate. Depression stalked the land.

The year was 1836.

The nexus of excess speculation, political mischief, and financial disaster—the same tangle that led to our present economic crisis—has been long and deep. Its nature has changed over the years as Americans have endeavored, with varying success, to learn from the mistakes of the past. But it has always been there, and the commonalities from era to era are stark and stunning. Given the recurrence of these themes over the course of three centuries, there is every reason to believe that similar calamities will beset the system as long as human nature and human action play a role in the workings of markets.

Let us begin our account of the catastrophic effects of speculative bubbles and political gamesmanship with the collapse of 1836. Thanks to a growing population, prosperity, and the advancing frontier, poorly regulated state banks had been multiplying throughout the 1830’s. In those days, chartered banks issued paper money, called banknotes, backed by their reserves. From 1828 to 1836, the amount in circulation had tripled, from $48 million to $149 million. Bank loans, meanwhile, had almost quadrupled to $525 million. Many of the loans went to finance speculation in real estate.

Much of this easy-credit-induced speculation had been caused, as it happens, by President Andrew Jackson. This was a terrific irony, since Jackson, who served as President from 1829 until 1837, hated speculation, paper money, and banks. His crusade to destroy the Second Bank of the United States, an obsession that led him to withdraw all federal funds from its coffers in 1833, removed the primary source of bank discipline in the United States. Jackson had transferred those federal funds to state banks, thereby enabling their outstanding loans to swell.

The real-estate component of the crisis began to take shape in 1832, when sales by the government of land on the frontier were running about $2.5 million a year. Some of the buyers were prospective settlers, but most were speculators hoping to turn a profit by borrowing most of the money needed and waiting for swiftly-rising values to put them in the black. By 1836, annual land sales totaled $25 million; in the summer of that year, they were running at the astonishing rate of $5 million a month.

While Jackson, who was not economically sophisticated, did not grasp how his own actions had fueled the speculation, he understood perfectly well what was happening. With characteristic if ill-advised decisiveness, he moved to stop it. Since members both of Congress and of his cabinet were personally involved in the speculation, he faced fierce opposition. But in July, as soon as Congress adjourned for the year, Jackson issued an executive order known as the “specie circular.” This forbade the Land Office to accept anything but gold and silver (i.e., specie) in payment for land. Jackson hoped that the move would dampen the speculation, and it did. Unfortunately, it did far more: people began to exchange their banknotes for gold and silver. As the demand for specie soared, the banks called in loans in order to stay liquid.

The result was a credit crunch. Interest rates that had been at 7 percent a year rose to 2 and even 3 percent a month. Weaker, overextended banks began to fail. Bankruptcies spread. Even several state governments found they could not roll over their debts, forcing them into default. By April 1837, a month after Jackson left the presidency, the great New York diarist Philip Hone noted that “the immense fortunes which we heard so much about in the days of speculation have melted like the snows before an April sun.”

The longest depression in American history had set in. Recovery would not begin until 1843. In Charles Dickens’s A Christmas Carol, published that same year, Ebenezer Scrooge worries that a note payable to him in three days might be as worthless as “a mere United States security.”

Modern standards preclude government officials and members of Congress from the sort of speculation that was rife in the 1830’s. But today’s affinities between Congressmen and lobbyists, affinities fueled by the largess of political-action committees, have produced many of the same consequences.

Consider the savings-and-loan (S&L) debacle of the 1980’s. The crisis, which erupted only two decades ago but seems all but forgotten, was almost entirely the result of a failure of government to regulate effectively. And that was by design. Members of Congress put the protection of their political friends ahead of the interests of the financial system as a whole.

After the disaster of the Great Depression, three types of banks still survived—artifacts of the Democratic Party’s Jacksonian antipathy to powerful banks. Commercial banks offered depositors both checking and savings accounts, and made mostly commercial loans. Savings banks offered only savings accounts and specialized in commercial real-estate loans. Savings-and-loan associations (“thrifts”) also offered only savings accounts; their loan portfolios were almost entirely in mortgages for single-family homes.

All this amounted, in effect, to a federally mandated cartel, coddling those already in the banking business and allowing very few new entrants. Between 1945 and 1965, the number of S&L’s remained nearly constant at about 8,000, even as their assets grew more than tenfold from almost $9 billion to over $110 billion. This had something to do with the fact that the rate of interest paid on savings accounts was set by federal law at .25 percent higher than that paid by commercial banks, in order to compensate for the inability of savings banks and S&L’s to offer checking accounts. Savings banks and S&L’s were often called “3-6-3” institutions because they paid 3 percent on deposits, charged 6 percent on loans, and management hit the golf course at 3:00 p.m. on the dot.

These small banks were very well connected. As Democratic Senator David Pryor of Arkansas once explained:

You got to remember that each community has a savings-and-loan; some have two; some have four, and each of them has seven or eight board members. They own the Chevy dealership and the shoe store. And when we saw these people, we said, gosh, these are the people who are building the homes for people, these are the people who represent a dream that has worked in this country.

They were also, of course, the sorts of people whose support politicians most wanted to have—people who donated campaign money and had significant political influence in their localities.

The banking situation remained stable in the two decades after World War II as the Federal Reserve was able to keep interest rates steady and inflation low. But when Lyndon Johnson tried to fund both guns (the Vietnam War) and butter (the Great Society), the cartel began to break down.

If the government’s first priority had been the integrity of the banking system and the safety of deposits, the weakest banks would have been forced to merge with larger, sounder institutions. Most solvent savings banks and S&L’s would then have been transmuted into commercial banks, which were required to have larger amounts of capital and reserves. And some did transmute themselves on their own. But by 1980 there were still well over 4,500 S&L’s in operation, relics of an earlier time.

Why was the integrity of the banking system not the first priority? Part of the reason lay in the highly fragmented nature of the federal regulatory bureaucracy. A host of agencies—including the Comptroller of the Currency, the Federal Reserve, the FDIC and the FSLIC, state banking authorities, and the Federal Home Loan Bank Board (FHLBB)—oversaw the various forms of banks. Each of these agencies was more dedicated to protecting its own turf than to protecting the banking system as a whole.

Adding to the turmoil was the inflation that took off in the late 1960’s. When the low interest rates that banks were permitted to pay failed to keep pace with inflation, depositors started to look elsewhere for a higher return. Many turned to money-market funds, which were regulated by the Securities and Exchange Commission rather than by the various banking authorities and were not restricted in the rate of interest they could pay. Money began to flow out of savings accounts and into these new funds, in a process known to banking specialists by the sonorous term “disintermediation.”

By 1980, with inflation roaring above 12 percent—the highest in the country’s peacetime history—the banks were bleeding deposits at a prodigious rate. The commercial banks could cope; their deposit base was mostly in checking accounts, which paid no interest, and their lending portfolios were largely made up of short-term loans whose average interest rates could be quickly adjusted, not long-term mortgages at fixed interest. But to the savings banks and S&L’s, disintermediation was a mortal threat.

Rather than taking the political heat and forcing the consolidation of the banking industry into fewer, stronger, and more diversified banks, Washington rushed to the aid of the ailing S&L’s with quick fixes that virtually guaranteed future disaster. First, Congress eliminated the interest-rate caps. Banks could now pay depositors whatever rates they chose. While it was at it, Congress also raised the amount of insurance on deposits, from $40,000 to $100,000 per depositor.

At the same time, the Federal Home Loan Bank Board changed the rules on brokered deposits. Since the 1960’s, brokers had been making, on behalf of their customers, multiple deposits equal to the limit on insurance. This allowed wealthy customers to possess insured bank deposits of any cumulative size—an end-run around the limit that should never have been tolerated in the first place. Realizing that these deposits were “hot money,” likely to chase the highest return, the Home Loan board forbade banks to have more than five percent of their deposit base in such instruments. But in 1980 it eliminated the restriction.

With no limits on interest rates that could be paid and no risk of loss to the customers, the regulators and Congress had created an economic oxymoron: a high-yield, no-risk security. As money flowed in to take advantage of the situation, the various S&L’s competed among themselves to offer higher and higher interest rates. Meanwhile, however, their loan portfolios were still in long-term home mortgages, many yielding low interest.

As a result, they went broke. In 1980 the S&L’s had a collective net worth slightly over $32 billion. By December 1982 that number had shrunk to less than $4 billion.

To remedy the disaster caused by the quick fixes of 1980, more quick fixes were instituted. The FHLBB lowered reserve requirements—the amount of money that banks must keep in highly liquid form, like Treasury notes, in order to meet any demand for withdrawals—from 5 to 3 percent of deposits. “With the proverbial stroke of the pen,” the journalist L.J. Davis wrote, “sick thrifts were instantly returned to a state of ruddy health, while thrifts that only a moment before had been among the dead who walk were now reclassified as merely enfeebled.”

For good measure, the Bank Board changed its accounting rules, allowing the thrifts to show handsome profits when they were, in fact, going bust. It was a case of regulators authorizing the banks they regulated to cook the books. Far worse, the rule that only locals could own an S&L was eliminated. Now anyone could buy a thrift. High-rollers began to move in, delighted to be able to assume the honorific title of “banker.”

And Congress, ever anxious to help the Chevy dealers and shoe-store owners, lifted the limits on what the thrifts themselves could invest in. No longer were they limited to low-interest, long-term, single-family mortgages. Now they could lend up to 70 percent of their portfolios for commercial real-estate ventures and consumer needs. In short, Congress gave the S&L’s permission to become full-service banks without requiring them to hold the capital and reserves of full-service banks.

Now came the turn of state-chartered thrifts, whose managers understandably wanted to enjoy the same freedoms enjoyed by federally-chartered S&L’s. State governments from Albany to Sacramento were obliging. California, which had the largest number of state-chartered S&L’s, allowed them to invest in anything from junk bonds to start-up software companies—in effect, to become venture-capital firms using government-guaranteed money. The consequence, as predictable as the next solar eclipse, was a collapse of the S&L’s en masse. Between 1985 and 1995, over a thousand were shut down by the government or forced to merge. The cost to the public is estimated to have run $160 billion.

Thrift Regulators (Dick Pratt, Chairman of the FHLBB in particular) were pressing the industry to seek higher yields in the commercial real estate loan arena. Then, when the Thrifts were in full cry after yield and booked as much as they could stomach of commercial RE loans, Congress passed the Tax Reform Act of 1976 which reduced the tax benefits of ownership of commercial real estate. Developers started “mailing the keys back” to the Thrifts. What the big print giveth, Congress takes away.

As the sorry tale of the S&L crisis suggests, the road to financial hell is sometimes paved with good intentions. There was nothing malign in attempting to keep these institutions solvent and profitable; they were of long standing, and it seemed a noble exercise to preserve them. Perhaps even more noble, and with consequences that have already proved much more threatening, was the philosophy that would eventually lead the United States into its latest financial crisis—a crisis that begins, and ends, with mortgages.

A mortgage used to stay on the books of the issuing bank until it was paid off, often twenty or thirty years later. This greatly limited the number of mortgages a bank could initiate. In 1938, as part of the New Deal, the federal government established the Federal National Mortgage Association, nicknamed Fannie Mae, to help provide liquidity to the mortgage market.

Fannie Mae purchased mortgages from initiating banks and either held them in its own portfolio or packaged them as mortgage-backed securities to sell to investors. By taking these mortgages off the books of the issuing banks, Fannie Mae allowed the latter to issue new mortgages. Being a government entity and thus backed by the full faith and credit of the United States, it was able to borrow at substantially lower interest rates, earning the money to finance its operations on the difference between the money it borrowed and the interest earned on the mortgages it held.

Together with the GI Bill of 1944, which guaranteed the mortgages issued to veterans, Fannie Mae proved a great success. The number of Americans owning their own homes climbed steadily, from fewer than 15 percent of non-farm families in the 1930’s to nearly 70 percent by the 1980’s. Thus did Fannie Mae and the GI Bill prove to be powerful engines for increasing the size of the middle class.

It can be argued that 70 percent is about as high a proportion as could, or should, be hoped for in home ownership. Many young people are not ready to buy a home; many old people prefer to rent. Some families move so frequently that home ownership makes no sense. Some people, like Congressman Charlie Rangel of New York, take advantage of local rent-control laws to obtain housing well below market rates, and therefore have no incentive to buy.

And some families simply lack the creditworthiness needed for a bank to be willing to lend them money, even on the security of real property. Perhaps their credit histories are too erratic; perhaps their incomes and net worth are lower than bank standards; or perhaps they lack the means to make a substantial down payment, which by reducing the amount of the mortgage can protect a bank from a downturn in the real-estate market.

But historically there was also a class, made up mostly of American blacks, for whom home ownership was out of reach. Although simple racial prejudice had long been a factor here, it was, ironically, the New Deal that institutionalized discrimination against blacks seeking mortgages. In 1935 the Federal Housing Administration (FHA), established in 1934 to insure home mortgages, asked the Home Owner’s Loan Corporation—another New Deal agency, this one created to help prevent foreclosures—to draw up maps of residential areas according to the risk of lending in them. Affluent suburbs were outlined in blue, less desirable areas in yellow, and the least desirable in red.

The FHA used the maps to decide whether or not to insure a mortgage, which in turn caused banks to avoid the redlined neighborhoods. These tended to be in the inner city and to comprise largely black populations. As most blacks at this time were unable to buy in white neighborhoods, the effect of redlining was largely to exclude even affluent blacks from the mortgage market.

Even after the end of Jim Crow in the 1960’s, the effect of redlining lingered, perhaps more out of habit than of racial prejudice. In 1977, responding to political pressure to abolish the practice, Congress finally passed the Community Reinvestment Act, requiring banks to offer credit throughout their marketing areas and rating them on their compliance. This effectively outlawed redlining.

Then, in 1995, regulations adopted by the Clinton administration took the Community Reinvestment Act to a new level. Instead of forbidding banks to discriminate against blacks and black neighborhoods, the new regulations positively forced banks to seek out such customers and areas. Without saying so, the revised law established quotas for loans to specific neighborhoods, specific income classes, and specific races. It also encouraged community groups to monitor compliance and allowed them to receive fees for marketing loans to target groups.

But the aggressive pursuit of an end to redlining also required the active participation of Fannie Mae, and thereby hangs a tale. Back in 1968, the Johnson administration had decided to “adjust” the federal books by taking Fannie Mae off the budget and establishing it as a “Government Sponsored Enterprise” (GSE). But while it was theoretically now an independent corporation, Fannie Mae did not have to adhere to the same rules regarding capitalization and oversight that bound most financial institutions. And in 1970 still another GSE was created, the Federal Home Loan Mortgage Corporation, or Freddie Mac, to expand further the secondary market in mortgage-backed securities.

This represented a huge moral hazard. The two institutions were supposedly independent of the government and owned by their stockholders. But it was widely assumed that there was an implicit government guarantee of both Fannie and Freddie’s solvency and of the vast amounts of mortgage-based securities they issued. This assumption was by no means unreasonable. Fannie and Freddie were known to enjoy lower capitalization requirements than other financial institutions and to be held to a much less demanding regulatory regime. If the United States government had no worries about potential failure, why should the market?

Forward again to the Clinton changes in 1995. As part of them, Fannie and Freddie were now permitted to invest up to 40 times their capital in mortgages; banks, by contrast, were limited to only ten times their capital. Put briefly, in order to increase the number of mortgages Fannie and Freddie could underwrite, the federal government allowed them to become grossly undercapitalized—that is, grossly to reduce their one source of insurance against failure. The risk of a mammoth failure was then greatly augmented by the sheer number of mortgages given out in the country.

That was bad enough; then came politics to make it much worse. Fannie and Freddie quickly evolved into two of the largest financial institutions on the planet, with assets and liabilities in the trillions. But unlike other large, profit-seeking financial institutions, they were headquartered in Washington, D.C., and were political to their fingertips. Their management and boards tended to come from the political world, not the business world. And some were corrupt: the management of Fannie Mae manipulated the books in order to trigger executive bonuses worth tens of millions of dollars, and Freddie Mac was found in 2003 to have understated earnings by almost $5 billion.

Both companies, moreover, made generous political contributions, especially to those members of Congress who sat on oversight committees. Their charitable foundations could be counted on to kick in to causes that Congressmen and Senators deemed worthy. Many of the political contributions were illegal: in 2006, Freddie was fined $3.8 million—a record amount—for improper election activity.

By 2007, Fannie and Freddie owned about half of the $12 trillion in outstanding mortgages, an unprecedented concentration of debt—and of risk. Much of the debt was concentrated in the class of sub-prime mortgages that had proliferated after the 1995 regulations. These were mortgages given to people of questionable credit standing, in one of the attempts by the federal government to increase home ownership among the less well-to-do.

Since banks knew they could offload these sub-prime mortgages to Fannie and Freddie, they had no reason to be careful about issuing them. As for the firms that bought the mortgage-based securities issued by Fannie and Freddie, they thought they could rely on the government’s implicit guarantee. AIG, the world’s largest insurance firm, was happy to insure vast quantities of these securities against default; it must have seemed like insuring against the sun rising in the West.

Wall Street, politicians, and the press all acted as though one of the iron laws of economics, as unrepealable as Newton’s law of universal gravity, had been set aside. That law, simply put, is that potential reward always equals potential risk. In the real world, unfortunately, a high-yield, no-risk investment cannot exist.

In 2006, after an astonishing and unsustainable climb in home values, the inevitable correction set in. By mid-2007, many sub-prime mortgages were backed by real estate that was now of lesser value than the amount of debt. As the market started to doubt the soundness of these mortgages, their value and even their salability began to deteriorate. So did the securities backed by them. Companies that had heavily invested in sub-prime mortgages saw their stock prices and their net worth erode sharply. This caused other companies to avoid lending them money. Credit markets began to tighten sharply as greed in the marketplace was replaced by fear.

A vicious downward spiral ensued. Bear Stearns, the smallest investment bank on Wall Street, was forced into a merger in March with JPMorgan Chase, with guarantees from the Federal Reserve. Fannie and Freddie were taken over by the government in early September; Merrill Lynch sold itself to Bank of America; AIG had to be bailed out by the government to the tune of $85 billion; Lehman Brothers filed for bankruptcy; Washington Mutual became the biggest bank failure in American history and was taken over by JPMorgan Chase; to avoid failure, Wachovia, the sixth largest bank in the country, was taken over by Wells Fargo. The most creditworthy institutions saw interest rates climb to unprecedented levels—even for overnight loans of bank reserves, which are the foundation of the high-functioning capitalist system of the West. Finally it became clear that only a systemic intervention by the government would stem the growing panic and allow credit markets to begin to function normally again.

Many people, especially liberal politicians, have blamed the disaster on the deregulation of the last 30 years. But they do so in order to avoid the blame’s falling where it should—squarely on their own shoulders. For the same politicians now loudly proclaiming that deregulation caused the problem are the ones who fought tooth and nail to prevent increased regulation of Fannie and Freddie—the source of so much political money, their mother’s milk.

To be sure, there is more than enough blame to go around. Forgetting the lessons of the past, Wall Street acted as though the only direction that markets and prices could move was up. Credit agencies like Moody’s, Standard & Poor’s, and Fitch gave high ratings to securities that, in retrospect, they clearly did not understand. The news media did not even try to investigate the often complex economics behind the housing market.

But remaining at the heart of the financial beast now abroad in the world are Fannie Mae and Freddie Mac and the mortgages they bought and turned into securities. Protected by their political patrons, they were allowed to pile up colossal debt on an inadequate capital base and to escape much of the regulatory oversight and rules to which other financial institutions are subject. Had they been treated as the potential risks to financial stability they were from the beginning, the housing bubble could not have grown so large and the pain that is now accompanying its end would not have hurt so much.

Herbert Hoover famously remarked that “the trouble with capitalism is capitalists. They’re too greedy.” That is true. But another and equal trouble with capitalism is politicians. Like the rest of us, they are made of all-too-human clay and can be easily blinded to reality by naked self-interest, at a cost we are only now beginning to fathom.

About the Author

John Steele Gordon is the author of, among other books, An Empire of Wealth: The Epic Story of American Economic Power (2004). His “Look Who’s Afraid of Free Trade” appeared in the February COMMENTARY.

A Failed Social Program Almost Destroyed our Economy

The law of unintended consequences tied with the inability of the 51% of Americans who don't pay income taxes to understand the dangers to the economy of voting themselves government largess have come within a whisker of destroying our economy.

With the CRA act of 1978, we tried to move our low and no earners from housing projects (a good thing) into houses that they couldn't afford. Crash in 2008.

Congress is still trying to "jiggle" this same model, give them a loan that they can't repay in housing and - soon - in all forms of credit with the new Federal Credit Protection Act.

Any wonder that our system crashed?
An wonder that banks won't make loans? If they make you a loan, they will have to make a similar loan to EVERYONE!

Until congress comes to its senses, this spiral will continue until we have truly destroyed our economy - and a large part of the economies of the rest of the world.

Three Years Later with Fannie and Freddie

The GSEs: Where Do We Stand?

William Poole, President FRB of St. Louis
Jan. 17, 2007

One of the Federal Reserve’s most important responsibilities is maintenance of financial stability. The job obviously, and sometimes dramatically, encompasses crisis response. However, the very existence of a crisis, when one occurs, often demonstrates a failure of some sort, on the part of the firms involved, the government or the Federal Reserve. It would not be difficult to cite examples of such failures.

Not long after coming to the St. Louis Fed in 1998, I became interested in Government Sponsored Enterprises, or GSEs. My interest arose when I began digging into aggregate data on the financial markets and discovered how large these firms are. The bulk of all GSE assets are in the housing GSEs—Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks. Using information as of Sept. 30, 2006—the latest available as of this writing—these 14 firms have total assets of $2.67 trillion; given their thin capital positions, their total liabilities are only a little smaller. Just two firms—Fannie Mae and Freddie Mac—account for $1.65 trillion of the assets, or 62 percent of all housing GSE assets. Moreover, Fannie Mae and Freddie Mac have guaranteed mortgage-backed securities outstanding of $2.82 trillion. Thus, the housing GSE liabilities on their balance sheets and guaranteed obligations off their balance sheets are about $4.47 trillion, which may be compared with U.S. government debt in the hands of the public of $4.83 trillion.

In what follows, I’ll confine most of my comments to Fannie Mae and Freddie Mac, where the largest issues arise. My purpose is to make the case once again that failure to reform these firms leaves in place a potential source of financial crisis. Although there is pending legislation in Congress, a major restructuring of these firms and genuine reform appear to be as distant as ever.

My initial curiosity about the GSEs was stoked simply by the size of these firms. As I investigated further, I became concerned about their thin capital positions and the realization that if any of them got into financial trouble the markets and the federal government would look to the Federal Reserve to deal with the problem. As I worked through the issues, I began to speak on the subject; my first such speech was in October 2001.(1) I last spoke on a GSE topic two years ago, before the St. Louis Society of Financial Analysts. My title then was “GSE Risks.”(2) Given that the risks did not seem likely to disappear any time soon, about six months ago I settled on this date and a GSE topic once again.

Today I want to look back over the past few years to summarize a few of the changes that have occurred at the GSEs and in the regulatory environment they face. It is no exaggeration to say these have been event-filled years for the GSEs, primarily because of disclosures of accounting irregularities at Fannie Mae and Freddie Mac. Although these firms stopped growing when the irregularities were disclosed, I will emphasize that once they get their houses in good order they will likely resume rapid growth because of the special advantages they enjoy in the marketplace from their ties to the federal government. I remain hopeful that Congress will eventually pass meaningful GSE reform legislation. Private-sector financial firms ought to have an intense interest in reform legislation. Still, given that there seems to be so little appreciation of the importance of the GSE issue, where do they—and we—go from here?

Before proceeding, I want to emphasize that the views I express here are mine and do not necessarily reflect official positions of the Federal Reserve System. I thank my colleagues at the Federal Reserve Bank of St. Louis for their comments—especially Bill Emmons, senior economist, who provided special assistance. However, I retain full responsibility for errors.
The Housing GSEs since June 9, 2003

Although the housing GSEs are less obscure than they used to be, they are not much discussed in recent months. A year ago I would have noted that it was not unusual to find stories about the GSEs on the front pages of major financial newspapers. They were the subject of substantial debate in Congress and among financial-policy experts. They had escaped from obscurity, primarily because of publicity in recent years over their accounting irregularities. But today they seem to be returning to obscurity.

For Fannie Mae and Freddie Mac, the two stockholder-owned housing GSEs, history can be divided into two distinct eras—before June 2003 and after. June 9, 2003, was the day the board of directors of Freddie Mac announced discovery of significant accounting irregularities. The stock prices of both Freddie Mac and Fannie Mae plunged, as investors immediately realized that something might have gone terribly wrong with both GSEs. Subsequent investigations by private experts and public authorities confirmed the fears of many investors and financial supervisors. These giant, fast-growing firms had poor accounting systems and financial controls.

Because it is important for my analysis later, keep in mind these facts: First, the effect of disclosure of accounting irregularities at Freddie Mac on June 9, 2003 led to a decline of 16 percent in Freddie’s stock price and 5 percent in Fannie’s stock price that day. However, as I’ll document later, the effect of these disclosures on the mortgage market was negligible. Similarly, when Fannie’s accounting irregularities were disclosed on Sept. 22, 2004, its stock fell by 6.5 percent that day and by a total of 13.5 percent over a three-day period; the mortgage rate was again unaffected.

Fortunately for financial stability, the accounting irregularities at Freddie Mac had been designed, as we later learned, to understate earnings by a total of about $9 billion over a period of years. Thus, there was no question of Freddie Mac defaulting on any of its obligations and immediately unleashing unpredictable effects on its counterparties or the financial system. In 2004, we learned that Fannie Mae’s accounting was revealed to be faulty. In December 2006, Fannie restated its earnings for 2002, 2003 and the first half of 2004, revealing that it had overstated its earnings by a total of about $6 billion.

Fannie and Freddie are supervised by the Office of Federal Housing Enterprise Oversight, or OFHEO. In both cases, OFHEO’s early response to disclosure of the accounting irregularities was to declare the enterprises “significantly undercapitalized” because their extremely high leverage makes uncertainty of any kind about the true capital backing of their portfolios a risk to their own safety and soundness, as well as to the stability of the financial system. Beginning in the first quarter of 2004, OFHEO required Freddie Mac to hold capital at least 30 percent above the statutory minimum level; OFHEO imposed the identical requirement on Fannie Mae in the third quarter of 2005. In addition, OFHEO required the firms to correct their accounting; undertake a thorough review of corporate governance, incentives and compensation; appoint an independent chief risk officer; and refrain from increasing their retained portfolios.

The stunning accounting irregularities at Freddie Mac and Fannie Mae served as wake-up calls both to the GSEs themselves and to the supervisory and legislative communities. Freddie Mac fired virtually all of its top-level management immediately in June 2003, and then, a few months later, fired the new CEO it had hired to replace the original disgraced CEO.(3) Barely a year and a half later, Fannie Mae ejected its own top managers, who had repeatedly declared that, unlike Freddie’s, its own books were clean. The boards of both companies agreed to a series of governance reforms designed to bring the GSEs into line with other large financial firms. Hundreds of millions of shareholder dollars were committed to rebuilding accounting and control systems at both firms. Both firms agreed to restate earnings for the past few years; so massive was this undertaking that neither firm is current on its financial reporting. Freddie did release its annual report for 2005 but, according to its press release of Jan. 5, 2007, may revise its results materially for the first nine months and the third quarter of 2006. Nor is Fannie filing current reports. In December 2006, Fannie filed its Form 10-K for 2004 with the SEC. Currently, investors in common stock or debt obligations issued by both companies rely on partial and incomplete information subject to material revision.

The GSE accounting scandals constituted a rude awakening for OFHEO and Congress. OFHEO was caught napping at Freddie Mac but, to its credit, then identified Fannie Mae’s shortcomings on its own. Once alerted to the problems, OFHEO’s tenacious investigations into wrongdoing at both Freddie Mac and Fannie Mae spurred investigations by the Securities and Exchange Commission and the Department of Justice. Congressional hearings were held, and GSE reform legislation was passed in oversight committees of both houses of Congress in 2004 and 2005, although no final legislation has been enacted as of this time. I’ll have more to say about reform legislation later, because I think this is an important missing piece of the overall puzzle.

Meanwhile, the Federal Home Loan Banks—the “other housing GSEs”—were enduring accounting and control crises of their own. Two of the 12 FHLBs signed written regulatory agreements in 2004 with their supervisor, the Federal Housing Finance Board (FHFB), to rectify portfolio risk-management deficiencies. Then, in 2005, 10 of the 12 FHLBs failed to meet their agreed deadline to register their stock with the SEC. Like Fannie Mae and Freddie Mac, all of the Federal Home Loan Banks restated their earnings for recent years; all have now returned to timely filing of accounting statements.

So where do we stand? I would characterize the current situation as a period of uneasy waiting. The GSEs have grown much more slowly and they have been more reticent in public in recent quarters than they had been during the pre-2003 decade. It appears that they want to pursue a low-key strategy while memories of their accounting and control failures gradually fade. Their aim, apparently, is to return to the environment before heightened scrutiny arose in 2003.
What Has Been Accomplished: Analysis of GSE Risk

Although I think much more needs to be done, it would be a mistake to believe that nothing useful was done after severe accounting problems surfaced in June 2003. In general terms, the most important achievement is a much broader and better-informed discussion of the risks to financial stability posed by the GSEs.(4) We were fortunate that the GSE accounting and governance scandals did not threaten the immediate solvency of the enterprises and that the problems surfaced when the economy and financial markets were strong.

I will point to six major contributions to the public investigation into, and debate about, the risks posed by the GSEs. There have been other contributors, to be sure, but this list provides what I think is a good overview of the issues and what we have learned so far:

1. A 2003 study by Dwight Jaffee of interest-rate risks run by the GSEs;
2. A 2003 study by OFHEO of the potential systemic risks posed by the GSEs;
3. A series of testimonies and speeches by Federal Reserve Board Chairman Alan Greenspan;
4. A series of research papers prepared by Federal Reserve System staff members;
5. The results of a Federal Reserve ad-hoc study group investigating counterparty exposures and risks in the OTC interest-rate derivatives markets;
6. An economic-capital analysis of Fannie Mae and Freddie Mac prepared by Kenneth Posner, an equity analyst at Morgan Stanley.

These bullet points provide the flavor of some of the recent work on the GSEs. The appendix to this speech, available on the St. Louis Fed web site, provides a brief summary of each of these items and citations.
Considering these results as a whole, we have learned a great deal in recent years about the way the GSEs operate; the risks they are taking and how they attempt to manage them; and what effects the GSEs have on financial markets during normal times as well as during periods of market turbulence. Armed with this knowledge, lawmakers and policymakers are in a much better position to make needed improvements in the statutory and regulatory environment in which the GSEs operate.
The Case for Fundamental Reform

I continue to believe that the nation would be well-served by turning the GSEs into genuinely private firms, without government backing implied or explicit. If they bolster their capital, they can function perfectly well as purely private firms.

A key issue for many is whether privatizing Fannie and Freddie would raise mortgage rates paid by borrowers. We now have some solid evidence on how the mortgage market would function if the housing GSEs became fully private firms. A careful econometric investigation by three economists at the Board of Governors last year reached this conclusion: “We find that GSE portfolio purchases have no significant effects on either primary or secondary mortgage rate spreads.”(5) Put another way, the 30-year mortgage rate fluctuates in tandem with the rate on 10-year Treasury bonds, and the spread over the Treasury rate is not affected by portfolio purchases by Fannie and Freddie.

Another approach to acquiring evidence on the effects on the mortgage rate of mortgage purchases by Fannie and Freddie is to examine what happened when their portfolios stopped growing in the wake of disclosures of accounting irregularities. Those disclosures led OFHEO to impose 30-percent temporary surcharges on the firms’ required minimum capital levels. Freddie Mac’s capital surcharge was imposed in January 2004, while Fannie Mae’s capital surcharge became effective in September 2004.(6) To meet the higher capital ratio, the two firms had to do some combination of raising new capital and reducing their portfolios.

The retained portfolios of mortgages and mortgage-backed securities held by Fannie and Freddie grew strongly in the years preceding the OFHEO orders. For example, using year-end figures for 2002 and 2003, over the course of 2003, the two firms’ retained portfolios grew by a net of 12.3 percent, and at the end of 2003 they held 22 percent of outstanding mortgages on 1-4 family properties. Net growth of their retained portfolios then stopped; over the course of both 2004 and 2005, their total portfolios of mortgages and mortgage-backed securities fell slightly. In 2006, their retained portfolios continue to decline and by the end of the third quarter their portfolios were below year-end 2005. Meanwhile, the total market continued to expand. The combined market share of Fannie and Freddie fell from 22 percent at the end of 2003 to 14 percent at the end of the third quarter of 2006.

What happened to the mortgage spread when the GSEs stopped accumulating ever larger portfolios? Nothing. Because fixed-rate mortgages are subject to prepayment risk, whereas the 10-year Treasury bond is not, there is a degree of variability of the mortgage spread. But if the cessation of the GSEs’ portfolio growth had made a difference, it surely would have shown up in the data. The annual average of the spread in 2003, before the OFHEO orders that restricted Fannie and Freddie’s portfolio growth, was 180 basis points; the spread was 157 basis points in both 2004 and 2005.

Nor did we observe any sort of shock to the market when the accounting irregularities at Freddie were disclosed in June 2003. The spread was 196 basis points in May 2003, 198 basis points in June and 196 basis points in July. Consider also January 2004, when OFHEO imposed a capital surcharge on Freddie. That month, the mortgage spread was 159 basis points. The month before the spread was 161 basis points; the month after, 156 basis points. The OFHEO order applying to Fannie came in September 2004. That month the spread was 163 basis points; the month before, 159, the month after, 162.

Toward the beginning of my remarks I noted that disclosure of the accounting irregularities did affect the stock prices of the two firms. Now we see that there was no effect on the mortgage market. The issue, clearly, is the profitability of the firms and not effects on the mortgage market. The effects of problems at Fannie and Freddie on the mortgage market have been minimal because the market contains many competent and well-capitalized competitors that can readily pick up the slack when other players stumble.

Financial firms throughout the economy ought to have an intense interest in reforming the GSEs. One reason is simply that banks and other financial firms, and many nonfinancial firms, hold large amounts of GSE obligations and GSE-guaranteed mortgage-backed securities. I believe that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve and the federal government without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified and the “somehow” be specified. I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support but not capital.(7) As for the “somehow,” I urge you to be sure you understand the extent of the president’s powers to provide emergency aid, the likely speed of congressional action and the possibility that political disputes would slow resolution of the situation.

There is a long-run issue that goes beyond that of today’s systemic risk. The fact is that it is very profitable for a firm to be able to borrow at close to the Treasury rate, lend at the market rate and hold little capital. That is why the promise of constraints on the portfolio growth at Fannie and Freddie had a significant effect on their stock prices. Any firm with such a privileged position will want to extend its scope of operations. Over the past 15 years, Fannie Mae and Freddie Mac have grown much more rapidly than has the stock of mortgages outstanding and as a consequence now hold or guarantee a large fraction of U.S. home mortgages. They held in their portfolios 5 percent of 1-4 family mortgages at the end of 1990, the share peaked at 22 percent at the end of 2003, and, at the end of the third quarter of 2006, the share was 14 percent. Given the powerful incentive Fannie and Freddie have to grow, the systemic risk they pose to the economy will also grow.

Once their current accounting problems are fully resolved, Fannie and Freddie will want to resume their growth. It is simply very profitable to be able to borrow at close to the Treasury rate and invest in mortgages while holding minimal capital. Banks maintain capital ratios double or more the ratios that Fannie and Freddie maintain. Banks pay deposit insurance premiums to the Federal Deposit Insurance Corporation whereas Fannie and Freddie pay no insurance premiums. Assuming that the implied guarantee would, in a crisis, lead to a federal bailout, U.S. taxpayers bear the risk while the shareholders and managements of Fannie and Freddie enjoy the profits. This situation encourages these firms to grow vigorously.

These two firms, however, cannot meet their growth targets in the long run if they confine their operations to conforming home mortgages. Their interest in increasing the conforming mortgage limit is clear. Moreover, in my opinion it is inevitable that they will look for ways to extend their operations into new areas. They have that clear incentive because of the implicit federal guarantee they enjoy. For them to extend their operations into market segments already well served by existing private firms will not enhance the efficiency of mortgage markets or reduce costs to mortgage borrowers.

There are two possible ways to constrain the operations of the GSEs to areas with a clear public purpose. One is to end the implied federal guarantee so that Fannie Mae and Freddie Mac compete on an equal basis with other fully private firms. The other is to place restrictions on the size of their owned portfolios if they retain their privileged position. Their owned portfolios should be limited to mortgages held temporarily in the process of securitization.

Absent complete privatization, or on the way to it, Congress should strengthen the powers of OFHEO or a successor regulator. OFHEO has weaker powers than provided by law to the federal bank regulators—the Office of the Comptroller of the Currency, the Federal Reserve and the Federal Deposit Insurance Corporation. The GSE supervisory framework remains fragmented and weak, as the GAO has pointed out on numerous occasions.(8) Thus, structural change of the GSEs and their supervision should be at the top of the reform agenda. There is a glaring need for legislation to clarify the bankruptcy process should a GSE fail. At present, there is no process and no one knows what would happen if a GSE is unable to meet its obligations.

Freddie Mac and Fannie Mae both got into trouble with accounting irregularities in part because of the complexities under GAAP rules of accounting for derivatives positions and rules determining which assets should be reported at market and which should be reported at amortized historical cost. Sound risk management practices require that GSE managements base decisions on market values, or estimates as close to market as financial theory and practice permit. The reason is simple: Fannie Mae and Freddie Mac pursue policies that inherently expose the firms to an extreme asset/liability duration mismatch. They hold long-term mortgages and mortgage-backed securities financed by short-term liabilities. Given this strategy, they must engage in extensive operations in derivatives markets to create synthetically a duration match on the two sides of the balance sheet. These operations expose the firm to a huge amount of risk unless the positions are measured at market value.

Almost all the assets and liabilities of the GSEs are either traded actively in excellent markets or have values that can be accurately measured by prices in such markets. For this reason, the financial condition of the GSEs ought to be measured through fair-value accounting and such accounts ought to be the principal yardstick of condition and performance.
Conclusions

Since the GSE accounting scandals emerged in mid-2003, one thing has remained rock-solid: The GSEs have continued to borrow at yields only slightly higher than those of the U.S. government, and noticeably lower than those available to any other AAA-rated private company or entity. In other words, despite the vast recent accumulation of knowledge about the significant risks run by the GSEs, as well as their inability (or unwillingness) to manage these risks, investors in GSE debt securities appear unmoved. Upon reflection, the lack of market discipline evident during this crisis period is striking—like a dog that did not bark. This fact indicates to me that there still is a significant problem with the GSEs that needs to be fixed.

The obvious answer to why the dog did not bark is that the so-called “implicit guarantee”—that is, the belief by investors that the U.S. government would not allow the GSEs to default on their debt obligations—has not been removed. Indeed, the talk of increased GSE regulation and the failure of structural-reform legislation to become law may actually have reinforced the belief of many that, overall, the government is perfectly happy with the situation as it is. The GSEs remain politically powerful, if less strident than they were a few years ago.

Three essential reforms are needed to eliminate the GSEs’ threat to financial stability. First is a limit on their portfolio growth; second is an increase in their minimal required capital; third is satisfactory bankruptcy legislation so that, should the worst happen, federal authorities can deal with the problem in an orderly way.

Freddie Mac apparently does not expect any significant increases in constraints on its operations. Funds that could have been used to build capital to better protect taxpayers have instead been used to increase common stock dividends. Freddie set a quarterly dividend of $0.22 in the fourth quarter of 2002 and has increased the dividend every year since. As of the fourth quarter of 2006, the dividend stands at $0.50 per quarter, more than twice its level four years earlier. Fannie Mae cut its dividend in half in early 2005 to build capital, but I’ll hazard a guess that once it starts issuing regular financial statements the company will increase its dividend rather than build capital further.

I began this speech noting that the Federal Reserve has a responsibility to maintain financial stability. That responsibility includes increasing awareness of threats to stability and formation of recommendations for structural reform. I do not believe that a GSE crisis is imminent. However, for those who believe that a GSE crisis is unthinkable in the future, I suggest a course in economic history.
Footnotes

1. “The Role of Government in U.S. Capital Markets,” a Lecture Presented before the Institute of Governmental Affairs, University of California, Davis, Calif., Oct. 18, 2001, http://stlouisfed.org/news/speeches/2001/10_18_01.html.

2. Federal Reserve Bank of St. Louis Review, March/April 2005, Part 1, pp. 85-92.

3. Freddie Mac’s board of directors had misjudged at first how deeply ingrained the internal-control and governance problems were and had hired the former CFO to become the new CEO.

4. For a more detailed discussion of this topic, see my January 13, 2005 speech entitled “GSE Risks,” Federal Reserve Bank of St. Louis Review, March/April 2005, Part 1, pp. 85-92 (http://research.stlouisfed.org/publications/review/05/03/part1/Poole.pdf).

5. Lehnert, Andreas, Wayne Passmore, and Shane M. Sherlund, “GSEs, Mortgage Rates, and Secondary Market Activities,” Finance and Economics Discussion Series (2006-30, Sept. 8, 2006), Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. [http://www.federalreserve.gov/pubs/feds/2006/200630/200630pap.pdf] (forthcoming in the Journal of Real Estate, Finance and Economics). The quoted sentence is from the Abstract at the beginning of the paper.

6. See http://www.ofheo.gov/media/pdf/capclass93004.pdf.

7. For a discussion of Federal Reserve emergency powers, see William Poole, “Remarks,” Panel on Government Sponsored Enterprises, Federal Reserve Bank of Chicago, The 40th Annual Conference on Bank Structure & Competition [http://www.stlouisfed.org/news/speeches/2004/05_06_04.html].

8. Most recently, the GAO criticized GSE oversight in “Housing Government-Sponsored Enterprises: A New Oversight Structure is Needed,” Testimony of David M. Walker, Comptroller General, Government Accountability. Office, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, April 21, 2005, http://www.gao.gov/new.items/d05576t.pdf.

9. Dwight Jaffee, “The Interest Rate Risk of Fannie Mae and Freddie Mac,” Journal of Financial Services Research 24 (2003), No. 1, pp. 5-29.

10. “Systemic Risk: Fannie Mae, Freddie Mac, and the Role of OFHEO,” A Report to Congress by the Office of Federal Housing Enterprise Oversight, February 2003, http://www.ofheo.gov/Media/Archive/docs/reports/sysrisk.pdf.

11. These include:
Testimony of Chairman Alan Greenspan, “Regulatory Reform of the Government-Sponsored Enterprises,” Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, April 6, 2005, http://www.federalreserve.gov/boarddocs/testimony/2005/20050406/default.htm;
Speech by Chairman Alan Greenspan, “Risk Transfer and Financial Stability,” at the Federal Reserve Bank of Chicago’s 41st Annual Bank Structure Conference, May 5, 2005, http://www.federalreserve.gov/boarddocs/speeches/2005/20050505/default.htm;
Question and Answer Session After Testimony by Chairman Alan Greenspan, “Federal Reserve Board's Semiannual Monetary Policy Report to the Congress,” Before the Committee on Financial Services, U.S. House of Representatives, July 20, 2005.

12. These include:
“The GSE Implicit Subsidy and the Value of Government Ambiguity,” by Wayne Passmore, Real Estate Economics 33 (Fall 2005), 465-83.
“The Effect of Housing Government-Sponsored Enterprises on Mortgage Rates,” by Wayne Passmore, Shane M. Sherlund, and Gillian Burgess, Real Estate Economics 33 (Fall 2005), 427-63.
http://www.federalreserve.gov/pubs/feds/2005/200506/200506pap.pdf;
“GSEs, Mortgage Rates, and Secondary Market Activities,” by Andreas Lehnert, Wayne Passmore, and Shane M. Sherlund, Federal Reserve Board FEDS working paper 2006-30, September 2006, http://www.federalreserve.gov/pubs/feds/2005/200507/200507pap.pdf;
“An Analysis of the Potential Competitive Impacts of Basel II Capital Standards on U.S. Mortgage Rates and Mortgage Market Securitization,” by Diana Hancock, Andreas Lehnert, Wayne Passmore, and Shane M. Sherlund, Federal Reserve Board, Basel II White Paper No. 4, April 2005.
“Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire? by W. Scott Frame and Lawrence J. White, Journal of Economic Perspectives 19, Spring 2005, No. 2, pp. 159-84;
“Incentives Askew? Executive Compensation at Fannie Mae and Freddie Mac,” by William R. Emmons and Gregory E. Sierra, Regulation 27, Winter 2004, No. 4, pp. 22-28.

13. “Concentration and Risk in the OTC Markets for U.S. Dollar Interest Rate Options,” Prepared by staff of the Board of Governors of the Federal Reserve System (Patrick Parkinson, Michael Gibson) and the Federal Reserve Bank of New York (Patricia Mosser, Stefan Walter, Alex LaTorre), March 2005,
http://www.federalreserve.gov/BoardDocs/Surveys/OpStudySum/OptionsStudySummary.pdf.

14. “Fannie Mae, Freddie Mac, and the Road to Redemption,” by Kenneth Posner, Morgan Stanley Equity Research, July 2005.

Appendix: Summaries of Recent Studies on GSE Issues

Jaffee study of GSE interest-rate risk.(9) Dwight Jaffee was one of the first to “peer through” the public disclosures provided by the GSEs about the interest-rate risks they incurred and how they managed them. Jaffee concluded that the GSEs actually incurred significant interest-rate and liquidity risks, despite their own characterization of such risks as being minimal. Subsequent events and analysis have proven Jaffee correct.

OFHEO study of potential systemic risks posed by GSEs.(10) Even before the GSE accounting scandals broke, the GSEs’ safety-and-soundness supervisor had prepared a study comprising scenarios in which the GSEs might contribute to systemic risk. Although OFHEO concluded that the likelihood of one or both GSEs contributing to financial-system instability was very small, the agency recommended to Congress that its (OFHEO’s) supervisory powers should be enhanced to further safeguard the GSEs and the financial system.

Public statements by Chairman Alan Greenspan.(11) Federal Reserve Chairman Greenspan rejected the idea of stronger GSE regulation in favor of portfolio limits, stating that,
“World-class regulation, by itself, may not be sufficient and, indeed, might even worsen the potential for systemic risk if market participants inferred from such regulation that the government would be more likely to back GSE debt in the event of financial stress…. We at the Federal Reserve believe this dilemma would be resolved by placing limits on the GSEs’ portfolios of assets” (testimony in U.S. Senate, April 6, 2005).

Chairman Greenspan also drew attention to the strains the GSEs could place on the over-the-counter interest-rate derivatives markets due to their portfolio-hedging activities.

Research papers by Federal Reserve staff.(12) One of these papers estimated the pass-through by Fannie Mae and Freddie Mac of their funding-cost advantage into primary mortgage rates, finding a mere seven basis points of pass-through. Another paper provided evidence against the GSEs’ claims that their purchasing behavior stabilizes mortgage rates during periods of market turbulence. Other papers discuss likely competitive interactions between the GSEs and large banks that will be subject to Basel II capital regulation, and the ill-structured incentives the GSEs face to increase the size of their portfolios.

Ad-hoc Federal Reserve study group examining GSE impacts on interest-rate derivatives markets. (13) The study group identified potential channels through which disruptions at the GSEs could flow through to other market participants in the over-the-counter markets for interest-rate derivatives, like swaps, interest-rate options, and swaptions (options on swaps). The study group reported that market participants felt current risk-management practices were sufficient to contain risks posed by the GSEs.

Economic-capital analysis of GSEs by Morgan Stanley.(14) Kenneth Posner, an equity analyst at Morgan Stanley, isolated the distinct economic risks faced by the GSEs and estimated how much capital the firms would need in order to provide adequate protection to debtholders to justify an AA senior-unsecured bond rating. This analysis assumed that there would be no support forthcoming (or expected by financial-market participants) from the federal government. His estimate of the required equity-to assets capital ratio was in the range of four to seven percent, about twice as high as the current GSE ratios of closer to three percent. Thus, the GSEs would be significantly undercapitalized today if there were no expectation of government support of their liabilities.

What are "Fannie and Freddie"

Competition for Fannie Mae and Freddie Mac?

By W. Scott Frame, Federal Reserve Bank of Atlanta and
Lawrence J. White, New York University

From the Fall 2004 issue of Regulation, a publication of the Cato Institute found online at http://www.regulationmagazine.com.. The views expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Atlanta, the Federal Reserve System, or their staffs.

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are the two dominant entities in the finance of residential mortgages. Their rapid growth in the 1990s began attracting political attention earlier this decade. An increase in Fannie Mae's exposure to interest rate risk in 2002, followed by a widely reported accounting scandal at Freddie Mac in 2003, sharpened political concerns about the strength of the regulatory regime that surrounds the two entities.

Less widely recognized are two emerging and potentially powerful sources of new competition for Fannie Mae and Freddie Mac: an expanded mortgage finance program by the Federal Home Loan Bank System and new bank risk-based capital standards that are likely to be implemented in 2006. More competition should generally be welcomed. But this heightened competition could create incentives for Fannie Mae and Freddie Mac to take greater risks, with potentially unfavorable consequences for U.S. taxpayers. As a result, unless the two firms were to be privatized quickly (which is highly unlikely), enhanced regulatory scrutiny will be in order.

Background
Though both Fannie Mae and Freddie Mac are publicly traded companies, they are the creations of the federal government, having been established by specific acts of Congress. Consequently, they (along with the Federal Home Loan Bank System and a few other special entities) are often described as "government-sponsored enterprises" (GSEs).
The specific activities of Fannie Mae and Freddie Mac are virtually identical and consist of two components:
They issue mortgage-backed securities that carry corporate guarantees with respect to the credit (default) risk on the underlying residential mortgages.
They invest in large portfolios of residential mortgage-related assets (whole mortgages and their own mortgage-backed securities) that are funded almost entirely (about 96-97 percent) with debt raised in the securities markets.

Table 1 shows the year-end amounts of Fannie Mae and Freddie Mac's mortgage-backed securities outstanding and their mortgage-related assets held in portfolio for 2003 and selected earlier years of the past two decades. As can be seen, their growth has been breathtaking. Ranked by assets on their balance sheets, Fannie Mae and Freddie Mac currently are among the five largest firms in the United States.

Table 1 ($billion)

Year	Fannie Mae	Freddie Mac	GSEs	Total Mkt	GSE Share
1980	$56	$22	$78	$1,105	7.06%
1990	$402	$338	$740	$2,907	25.46%
2000	$1,315	$962	$2,277	$5,543	41.08%
2003	$2,202	$1,429	$3,631	$7,715	47.06%

Privileges and Limits Fannie Mae and Freddie Mac enjoy a number of special privileges as part of their federal charters.

• They are exempt from state and local income taxes;
• they are exempt from Securities and Exchange Commission (SEC) securities registration requirements and attendant fees;
• they each have potential lines of credit with the U.S. Treasury of up to $2.25 billion;
• their securities can be purchased by the Federal Reserve for open-market operations;
• they can use the Fed as their fiscal agent;
• and their securities can be purchased in unlimited quantities by banks and thrift institutions.

As an indicator of the "federalness" of their charters, the president can appoint five of their 18 board members. Also, as a practical recognition of their specialness, the financial pages of daily newspapers usually list prices and yields of Fannie Mae and Freddie Mac's debt issuances (along with those of other GSEs) in a special box labeled "government agency issues" that is usually located immediately adjacent to the box showing the prices and yields of Treasury debt.

Some of Fannie Mae and Freddie Mac's special privileges (e.g., tax exemptions, fee exemptions) have a direct effect in reducing their operating costs. However, the largest source of savings arises because their charter attributes (plus some important history) strongly suggest to the financial markets that, in the event that either company experienced serious financial difficulties, the federal government would likely not allow their creditors to suffer financial losses.

Known as the financial markets' belief in an "implied guarantee," this belief has allowed Fannie Mae and Freddie Mac to borrow huge sums at rates that are more favorable than their stand-alone credit rating (about AA-) would warrant. A common estimate of this borrowing advantage is about 35-40 basis points, although the differential varies with time and financial conditions, and with the specific characteristics of their debt instruments. (The extent of this borrowing advantage continues to be an active matter for academic and political debate.)

There are, however, also special limits on their activities.

• Their charters restrict Fannie Mae and Freddie Mac to residential mortgage finance,
• they cannot originate mortgages.
• They are subject to a maximum size of mortgage, linked to an index of housing prices. In 2004, this maximum mortgage for single-family residences is $333,700.
• The mortgages that they finance must also either be supported by a 20 percent down payment or have an external credit enhancement like mortgage insurance.
• Fannie Mae and Freddie Mac are subject to "mission" regulation by the Department of Housing and Urban Development, which mandates that they provide housing finance for low- and moderate-income households.
• And they are subject to safety-and-soundness regulation by the Office of Federal Housing Enterprise Oversight (OFHEO), an independent agency lodged within HUD. This safety-and-soundness regulation is a reflection of the federal government's concern about the likely political reality of the implied guarantee; paradoxically, this regulation may also strengthen the financial markets' belief in an implied guarantee.

The political reason for Fannie Mae and Freddie Mac's special privileges is the American polity's intent to reduce the financing costs of residential mortgages. It appears that about two-thirds of the borrowing advantages of Fannie Mae and Freddie Mac are passed on to borrowers in the form of lower interest costs -- about 25 basis points lower -- on conforming mortgages. (That figure, too, is the subject of much debate.) Though the political appeal of this apparent free lunch is readily apparent -- there is no on-budget entry for this benefit -- the potential liability to taxpayers from the implied guarantee is the true counterbalance.

From a larger perspective, because our society already heavily subsidizes the production and consumption of housing through a wide variety of programs at all levels of government, the social benefits from the additional stimulus that flows through Fannie Mae and Freddie Mac are questionable. Though there are good theoretical arguments for encouraging home ownership, and a growing empirical literature supports those arguments, that line of reasoning calls for a narrowly focused, on-budget program that would subsidize low- and moderate-income households that are on the cusp of renting or buying.

In reality, the programs that focus on lowering the costs of home ownership (e.g., the absence of capital gains taxes on most home sales, the deductibility from taxable income of mortgage interest and real estate taxes) are extremely broad in scope, tend to favor higher income households, and tend largely to encourage those households to buy larger and better-appointed homes and to buy second homes. The home-purchase encouragement provided through Fannie Mae and Freddie Mac is clearly in this broad-brush category and does little to raise the overall level of home ownership.

The two GSEs do not show any appreciably different record with respect to providing mortgage finance to low- and moderate-income households as compared to traditional lenders' efforts.

The rapid growth of Fannie Mae and Freddie Mac ... is surely the result of many factors. The growth of their securities business stems from the innovation and spread of the mortgage-backed securities process itself (which dates only to 1970) and the superior liquidity attributes of those securities. Favorable regulatory risk-based capital requirements -- banks and thrifts are required to hold 4 percent capital against a prime residential mortgage but only 1.6 percent against Fannie Mae and Freddie Mac's securities (or against any AA-rated mortgage-backed securities) -- surely fueled the expansion as well. As for the growth of the portfolio holdings of Fannie Mae and Freddie Mac, conscious business-model decisions by both companies to expand their portfolios in the early 1990s were a large part of the story, but their favorable borrowing costs (vis-à-vis non-depository borrowers) also contributed. (Whether the two GSEs have had a funding and/or regulatory advantage vis-à-vis depository institutions is more controversial; for one view, see Robert Van Order's article "A Microeconomic Analysis of Fannie Mae and Freddie Mac" in the Summer 2000 issue of Regulation.)

Competition
As we noted in the introduction, Fannie Mae and Freddie Mac face two emerging, potentially powerful sources of competition: the Federal Home Loan Bank System and new bank risk-based capital standards. Below, we look at those competitors carefully.

FHLB The Federal Home Loan Bank (FHLB) System consists of 12 "wholesale" banks that provide finance (in the form of loans, usually termed "advances") for more than 8,000 banks and thrifts that are members (and also shareholder-owners) of the system. Like Fannie Mae and Freddie Mac, the FHLBs are a GSE, with similar benefits and limits embedded in a congressional charter. They enjoy favorable borrowing rates in the financial markets and they pass on much of that advantage to members in the form of reduced interest rates on advances.

In 1997, the Federal Home Loan Bank of Chicago began purchasing pools of residential mortgages originated by members. Termed the "Mortgage Partnership Finance" program, the arrangement left most of the credit risk in the hands of the originator (in return for a credit enhancement fee paid to the originator) while the FHLB received the stream of interest and principal payments and managed the interest-rate risks associated with the pool. The program, and a second one similar to it, has since expanded. All 12 FHLBs currently participate in one or both of the programs. At year-end 2003, the FHLBs collectively held $113 billion in residential mortgage pools that had been purchased through the programs.

The FHLBs are enthusiastic about expanding the programs, so long as they can arrange for the additional capital to support their mortgage holdings. Another potential route for expansion would be for the FHLBs to decide to securitize the mortgage pools and sell the resulting mortgage-backed securities.

The programs' expansion means that the FHLBs are becoming rivals to Fannie Mae and Freddie Mac in the holding of residential mortgages. If the FHLBs were to decide to securitize their holdings, they would become rivals to Fannie Mae and Freddie Mac in the issuance of mortgage-backed securities. And the FHLB members who are originating and selling the mortgage pools to the FHLBs are becoming rivals to Fannie Mae and Freddie Mac in the issuance of credit guarantees on mortgage pools.

Basel II In 1988, the Basel Committee on Banking Supervision, meeting under the auspices of the Bank for International Settlements and representing the major industrial countries of the world, issued a set of capital guidelines for banks. The guidelines, known as "Basel I," became the accepted standard for most countries. A decade later, the committee issued a draft revision that updated the capital guidelines and greatly broadened their scope. The revision, known as "Basel II," has been revised a number of times since its issuance in 1999 and is currently scheduled to be implemented later this decade.

Under Basel II, there are three alternative approaches to the setting of banks' risk-based capital requirements. The "standard" approach largely continues the Basel I framework, and the capital requirement for holding prime residential mortgages will continue to be 4 percent. A second approach, known as the "foundation internal ratings-based approach," allows banks to use their own internal risk models for the determination of required capital, but regulators specify some of the parameters. The third approach, known as the "advanced internal ratings-based approach" (AIRB), permits banks to use their own internal risk models and parameters for the determination of required capital (subject to overall supervisory review).

A longstanding complaint about the Basel I requirements is that the required 'risk-based' capital levels for various assets are only loosely related to their underlying risks. That complaint has been especially relevant to prime residential mortgages, where the credit risks have been appreciably below the 4 percent capital requirement specified in Basel I.

The AIRB approach could yield capital requirements for residential mortgages that are in the 1-2 percent range. The 10 largest U.S. banks are likely to be required to use the AIRB approach, and the next 10 largest banks are likely to adopt the approach voluntarily. (The remaining U.S. banks will continue to use the Basel I system.) Those 20 large banks account for about two-thirds of U.S. banking assets and about one-half of residential mortgage assets held by banks.
Accordingly, under Basel II, the 20 banks will have enhanced incentives to retain mortgages in their own portfolios rather than sell them to Fannie Mae and Freddie Mac. The banks will also have greater incentives to compete with the two GSEs in purchasing mortgages from other originators. Because the large banks already account for a sizable fraction of residential mortgage activity, the expansion of competition from those banks could well be substantial.

The Consequences
Expansion of the FHLBs' mortgage programs and the implementation of the AIRB approach of the Basel II capital requirements for large U.S. banks will mean expanded competition for Fannie Mae and Freddie Mac. Such competition will affect their main lines of business: issuing credit guarantees on mortgage-backed securities and holding portfolios of residential mortgage-related assets. In turn, the expanded competition will likely mean narrower profit margins and reduced franchise values for Fannie Mae and Freddie Mac.

The experience of the past decade…shows that Fannie Mae and Freddie Mac have enjoyed substantial franchise value (as indicated by the ratio of market value to equity book value), as compared to the top 10 U.S. banks. The market's recognition of the GSEs' franchise value is not surprising, given their special (and substantial) advantages described above and the limited competition that they historically faced.

The new competition and the consequent reduced franchise value have important implications for the safety-and-soundness regulation of the two GSEs. An essential component of safety-and-soundness regulation is the requirement of adequate capital levels on the part of the regulated institution. Adequate capital not only provides a direct assurance that the level of assets will be adequate to cover the institution's liabilities, but it also provides a disincentive for the owners (or the managers operating on behalf of the owners) to take undue risks. Because the capital of the institution corresponds approximately with the owners' equity in the enterprise, more capital means that the owners have more to lose from the "downside" of risk-taking. With regard to that disincentive -- what the owners have to lose from undue risk-taking -- the appropriate measure of their stake in the enterprise encompasses the market value of their equity position and thus includes the franchise value of the institution.

The reduced franchise value for Fannie Mae and Freddie Mac that will follow from the heightened competition from the FHLBs and the Basel II banks will thus erode their effective capital and increase their incentives for risk-taking -- perhaps through less-than-complete hedging of interest-rate risks, less resources devoted to vetting credit risks, entry into riskier lines of residential mortgage finance, or perhaps even through newly created methods of risk-taking that we cannot imagine today. Though rational managers would forsake such measures when profits are high, shareholder unhappiness and pressures during abnormal times might well cause managers to come closer to the edge. Indeed, the accounting fiasco at Freddie Mac in 2003 can be interpreted as an example of the consequences of similar shareholder pressures (in that case, the pressures for smoothly rising reported earnings).

In principle, the safety-and-soundness regulatory system established by the OFHEO is supposed to detect and deter undue risk-taking. But the overall capabilities of the OFHEO have recently been called into question, as Congress and the Bush administration have mulled over, and also sparred over, a potential restructuring of the GSEs' regulation. And the expansion of risk-taking could well be subtle and difficult to detect. Costly "accidents" have been known to happen in the safety-and-soundness area, and they could well happen again.

In a perfect world, the American polity would realize that the social benefits of continuing Fannie Mae and Freddie Mac (and also the FHLBs) as GSEs fall short of the social costs, and true privatization of those enterprises would readily follow. With the disappearance of the "implicit guarantee," safety-and-soundness regulation could also disappear and private creditors would address the issues of heightened competition and the incentives for expanded risk-taking. But in our actual world, privatization of the GSEs is an unlikely event. Consequently, given the continued presence of the "implied guarantee," the appropriate focus must be on enhanced safety-and-soundness regulation (despite the paradoxical strengthening of the guarantee that might accompany enhanced regulation).

For all of those reasons, the scenario that we have outlined -- expanded competition, the likely reduction in Fannie Mae's and Freddie Mac's franchise values, and the concomitant increased incentives for risk-taking by the GSEs -- should be a wake-up call for heightened scrutiny by the OFHEO or whatever safety-and-soundness regulatory agency replaces it. The failure to heed this call could well prove costly to taxpayers.

W. Scott Frame is a financial economist and associate policy adviser in the research department for the Federal Reserve Bank of Atlanta.
Lawrence J. White is professor of economics at the Stern School of Business at New York University. From 1986 to 1989, he was a member of the Federal Home Loan Bank Board, with responsibilities that included being a Freddie Mac board member and overseeing the Federal Home Loan Bank System.