Mises Daily Articles
Freddie Mac: A Mercantilist Enterprise
The Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac, has recently come under close scrutiny after it was forced to restate its earnings upwards for several years. While it might be easy to dismiss this event as insignificant since earnings and profits were higher than initially reported, these restatements point to a serious problem associated with all Government Sponsored Enterprises (GSEs). The unfolding story involving Freddie Mac provides ample evidence that GSEs are a perversion of free enterprise and actually work to undercut the very essence of what a free market should be.
The Origins of Government Sponsored Enterprises
To understand the situation, one must study the history of the Federal Home Loan Banks and the Federal National Mortgage Association or Fannie Mae (Freddie Mac's larger sibling). These institutions were products of the New Deal. The mission of the Federal Home Loan Banks, which were created in 1932, was to provide financial support to urban thrift and savings banks. In 1938, the government created Fannie Mae with the express purpose of funding "mortgage loans insured by . . . the Federal Housing Administration."1 All of this occurred during a time of upheaval in financial markets and were supposedly the remedy needed. Like all such government projects aimed at solving various crises, the institutions outlived their initial purpose and tended to change their focuses to continue operations. Accordingly, in 1968, Fannie Mae was chartered as a GSE and stock was sold to investors. At that time numerous large private mortgage companies purchased stock in the new firm. Likewise, Freddie Mac was chartered as a GSE in 1970.2 However, Freddie Mac did not become a public company until 1989.3
Advocates for these GSEs argue that they provide liquidity in financial markets that would not exist otherwise. In the case of mortgage lending, proponents claim that Fannie Mae and Freddie Mac make it easier for low-income families to own homes. While these institutions have been privatized to a degree, they still remain tied to the federal government in some important respects. In fact, Fannie Mae and Freddie Mac have access to a guaranteed line of credit of $2.25 billion with the U.S. treasury.4 This guarantee, coupled by the perception that federal money would be used beyond the extent of the credit limit, allows both companies to maintain lower borrowing costs than would otherwise be the case. In many cases, the companies are able to sell bonds yielding only a few dozen basis points above U.S. treasury benchmarks. If the government's guarantee disappeared, the borrowing spreads for both companies would widen. Beyond the government's line of credit, these companies are also exempt from state and local income taxation and are exempt from SEC filings. Moreover, their securities are listed as government securities and can be held by banks and thrifts as low-risk bonds.5 These benefits provide a significant advantage since such privileges are not offered to other financial institutions.
For the most part, Fannie Mae and Freddie Mac have affected private mortgage markets by securitizing mortgages through the selling of bonds based. Freddie Mac veered from this strategy in the early 1990s when the company's management sought to generate higher profits. Though its business of securitizing mortgages was growing steadily, managers determined that the company could generate greater profitability by holding mortgages in a portfolio rather than by merely securitizing them through issuing bonds.6
However, as with any investment, a higher return typically entails accepting greater risk and this fact applies as much to Freddie Mac as it does to any other enterprise. In its original form of operation, securitizing mortgage contracts by selling bonds in the debt market passed on any interest rate risk to the bondholders. But, this situation changed dramatically when Freddie Mac began to hold mortgages in its own portfolio. Since most of the mortgages pay a fixed rate of interest, any change in interest rates can significantly affect the value of the portfolio. For this reason, Freddie Mac's management decided to hedge their exposure to fluctuations in the market rate of interest by using derivatives. One of the main instruments that the company uses is the over-the-counter derivative product called an interest rate swap.7 The swap market is used by global banks, brokers, and insurance companies everyday, and its usefulness is immeasurable. It allows financial companies to reduce risk. It also provides a means of financial speculation.8
Freddie Mac manages a portfolio valued in the hundreds of billions of dollars. Furthermore, the portfolio contains mortgages at different interest rates with different durations. The task of successfully hedging such a portfolio is monumental, and Freddie Mac is forced to engage in numerous interest rate swaps in an effort to attempt to protect itself from interest rate fluctuations.
The Origins of the Profit Understating Scandal
Freddie Mac's mortgage portfolio expanded rapidly in the 1990s and this forced the firm to use a variety of strategies aimed at immunizing their holdings against changes in interest rates. Senior management embraced derivative contracts because of their ability to significantly reduce the overall interest rate risk of the company's portfolio. In addition, these counter-party agreements had little or no public scrutiny. Unfortunately for the management of the firm, Freddie Mac's portfolio was not as well hedged as they might have liked it to be. As a result of fluctuations in interest rates, the company experienced various gains and losses on its portfolio holdings. The good news for Freddie Mac was that the gains more than covered the losses incurred in its various contracts and this resulted in a nice profit. However, instead of recording those profits in their quarterly financial releases, the company chose to hide them instead.9 This is certainly an odd response to greater than expected profitability since the general incentive of private companies is to post as large a profit as possible. Why, then, would a company purposely hide profits?
The answer that makes the most sense in this case is that hiding them was an attempt to protect the company's image on Wall Street. For years, Freddie Mac bonds had been considered a safe, stable investment. When the company was made public in 1989, it was largely assumed that this stability would carry over into the performance of its stock. Indeed, the securities of the company have provided consistent earnings, and with that, the company's stock has appreciated in value. Just the same, investors assigned a low risk profile to Freddie Mac because of its status as a GSE. The special government privileges extended to these companies have led many investors to conclude that both are somehow insulated from normal business and financial risk.
In other words, many think that the U.S. government would prevent Freddie Mac and Fannie Mae from failing financially if changes in the market worked against their portfolio values. Whether this assumption is correct or not is unclear. However, what is clear is that U.S. taxpayers are on the hook to bail out these institutions at least up to the line of credit and potentially could be called on to pay much more if they failed. In fact, rightly or wrongly, investors generally believe that this is the case given the low risk profile the companies enjoy.
Because of its status as a GSE and its special governmental privileges, Freddie Mac is consequently subject to oversight by the federal government. The Office of Federal Housing Enterprise Oversight (OFHEO) a division of Housing and Urban Development is charged with the task of regulating the actions of both Freddie Mac and Fannie Mae. It is likely that the decision to hide profits stemmed partly from worries they would spark the interest of some OFHEO officials.10 Whether or not this is true, the sudden and highly unusual fluctuations in the company's profits would certainly have generated significant interest among people in the Wall Street community as they attempted to assess the meaning of such earnings swings. Such interest would have exposed the greater risk associated with Freddie Mac's business strategy and caused its stock value to adjust accordingly. The net impact of the good news of greater profits coupled with the bad news of greater risk cannot be known, but company officials evidently did not want to test the waters.
Too big to fail? The Bigger Problem of GSEs
Many investors have been willing to look past the recent accounting scandal. They argue that since the earnings were restated upward, the company had in reality generated more profit than originally reported. Generally speaking, the investment community has continued to rely on the notion that the federal government will step in to keep the company afloat if bad things happen. This belief is likely correct. Thus, the issue of risk has been largely ignored. On the basis of the kind of strategy Freddie Mac currently pursues, its business is far more volatile than its credit rating suggests and, despite the use of derivatives, is extraordinarily exposed to interest rate risk. This simple fact means the company's past performance is in no way a barometer of future performance. The earnings suppression occurred during a period of declining interest rates. However, if the interest rate environment were to change dramatically, the company's significant gains in their portfolio could suddenly turn into significant losses. Indeed, it appears that the most recent monetary expansion being orchestrated by the Fed has led to a boom in the housing market as a result of depressed interest rates that are not likely to hold in the long-term. As this boom unravels and interest rates move upward, Freddie Mac could be left with large scale losses. The signs are already pointing in this direction. As interest rates bottomed out, Freddie Mac took a beating in the market. For 2003, the company's earnings plunged 52 percent.11 If this trend continues, large scale losses are likely.
Whether or not the federal government bails out Freddie Mac in such a financial disaster is unknown. However, it is clear that the company has continued to increase its portfolio holdings and this has increased its financial risk. Defenders of the company argue that its risk is manageable, and the likelihood of any major credit default negligible. However, it is unclear whether or not there are sufficient safeguards in place at Freddie Mac to secure it against losses that might arise from rising rates of interest. Moreover, since the company is not required to file audited financial documents with the Securities and Exchange Commission such information is not likely to be forthcoming.12 Even more troubling in this situation is the reality that the U.S. taxpayer will likely be responsible for guaranteeing the solvency of Freddie Mac in case of failure.
The accounting scandal at Freddie Mac raises the question of the wisdom of maintaining GSEs in a market economy. Proponents of them contend that without these companies the low-income housing market would most certainly suffer because corporations such as Freddie Mac provide liquidity. Yet, such an assumption is incorrect. If Fannie Mae and Freddie Mac no longer held a monopoly over the low-income secondary mortgage market, it is likely that other competitors would enter the marketplace. Such a scenario is not possible now since the two companies' governmental privileges significantly reduce financing costs, and in turn, their cost structures are lower than would be the case in a truly free market environment. In addition, the existence of these GSEs tends to hide the issue of business risk associated with all financial lending.
In fact, as one delves into the problems associated with Freddie Mac (and even Fannie Mae), one cannot help but focus on the company's low risk profile. Given the company's business strategy, even the casual observer realizes that such a profile is unwarranted. The real issue is, who is responsible for bearing the risk? Are investors going to bear the burden of loss if Freddie Mac fails? Or, will taxpayers be left to feel the pinch of that failure? Whatever the reality, it should be clear that the taxpayer should not be made responsible for financial failure if it occurs. If the company chooses to trade bonds or stocks, it should be allowed to do so. If Freddie Mac wants to purchase real estate, it is the company's choice. As long as the shareholders of Freddie Mac are afforded proper financial disclosure, it will be their decision as to what business strategy to pursue. However, it ought to be done in an entirely private way where the company accepts the total risk of its actions. In addition, the company ought to engage in its chosen strategy without any help from the federal government whatsoever.
In its current form Freddie Mac is a mercantilist company, and as such, it is not a good example of free enterprise. Freddie Mac should operate like any other publicly traded U.S. company. The remaining tie between it and the federal government should be severed once for all. When this happens, the truth about its situation will come to light and mortgage markets can operate more freely. Also, it is important that the U.S. taxpayer not be required to shoulder the burden for any of Freddie Mac's poor financial decisions. When this is done, financial markets can better assess the unsheltered business operating and financial risk. This will allow for a more accurate risk profile to arise, and for other private enterprises to compete. The day when Freddie Mac (and Fannie Mae) is forced to compete in the marketplace without any special privilege is long overdue. The current status quo is simply a perversion of the free market, and it must end.
- 1. Stanton, Thomas. Government Sponsored Enterprises: Mercantilist Companies in the Modern World, (Washington: The AEI press, 2002), pg. 10.
- 2. Ibid, pp. 86–90.
- 3. Barta, Patrick, et.al. "Behind Freddie Mac's Troubles: A strategy to take on more risk." The Wall Street Journal, September 22, 2003, pp. A1 & A12.
- 4. McKinley, Vern. "The Mounting Case for Privatizing Fannie Mae and Freddie Mac," Cato Policy Analysis (293) December 29, 1997, pg. 2.
- 5. Ibid, pg. 2.
- 6. Barta, op. cit., pp. A1 & A12.
- 7. Ibid.
- 8. Kolb, Robert, Financial Derivatives. (Cambrige: Blackwell Publishers, 1996) pp. 125–27.
- 9. Barta, op. cit., pg. A12.
- 10. McKinnon, John and Patrick Barta. "Freddie Mac finds new problems." The Wall Street Journal, November 24, 2003, pg. A2.
- 11. Hagerty, James R., "Freddie Mac's Earnings Plunge 52%," The Wall Street Journal, Thursday, July 1, 2004, pg. A3.
- 12. McKinley, op. cit.