The Free Market 20, no. 3 (March 2002)
The mortgage markets of America are on the verge of nationalization. Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System (all government-sponsored enterprises, or GSEs) have become giants in the mortgage markets. The Big Three have grown at such a rapid rate over recent years that at the end of 2000, they collectively held $2.9 trillion of mortgage debt, which was equivalent to nearly 56 percent of all US household mortgage debt. Combined, they account for 90 percent of the total federal agency debt, and federally sponsored agency debt outstanding at the end of 2000. In 2001, the growth of GSEs did not abate.
The expansion of the GSEs—neither wholly private nor wholly public institutions—has far outpaced the growth of the mortgage market as a whole, which means that their share of the mortgage pie is growing each year. This has led to predictions that the GSEs will inevitably nationalize mortgage risk by acquiring virtually all domestic mortgages. This thought leads not only to the prospect that American taxpayers will be the ones to foot the enormous bill of bailing out the GSEs if they should run into trouble, but also has led to fears that the GSEs will then have to expand their charters and enter more consumer markets in order to continue to grow.
For their part, the GSEs have remained supremely confident of their future and have aggressively fought any attempts to sever or disrupt their special relationship with the US government. The December issue of Money wrote of Franklin Raines, the CEO of Fannie Mae, that he "may be the most confident CEO in America." When asked whether any realistic economic scenario scared him, Raines replied, "No. . . . Our expectation is that in almost any environment, we can produce earnings growth in the mid-teens."
Forgotten is the truism that periods of prosperity necessarily precede periods of crisis. Thus, caution becomes heresy and optimism becomes the new religion. For Raines, the future can only look like the recently traversed past.
Perhaps Raines's view of realistic economic scenarios is a narrow one, but his confidence is not entirely without foundation. As Money reports, US home prices have yet to fall (year after year) in twenty-six years since the federal government has been tracking them. Moreover, Fannie Mae enjoys several important advantages that its competitors cannot ever replicate.
While Fannie Mae's stock and bond prospectuses carry the disclaimer that its obligations are not backed by the US government, the market believes something else. GSE obligations yield only slightly more than treasury securities, but below that of America's top-rated corporate obligations. And the rating agencies treat GSE obligations as if the US government backs them.
As Bert Ely stated in an American Enterprise Institute research briefing, "Anybody who has any doubts about these institutions has to realize that they are not only 'too big to fail' institutions, just by their sheer size, but again, if they got into trouble as the Farm Credit System did back in 1987, they would get bailed out. . . . Long-Term Capital Management was small potatoes in size compared to where Fannie and Freddie are today and where they're going." More recently, if the government can't sit by and watch the airlines perish or watch domestic steel producers fail, then it can hardly be expected to let these much larger giants fall.
The lower yields mean that the GSEs have a significant funding advantage over their competition. The GSEs also receive other benefits, as detailed in a research paper written for the Mercatus Center titled "Neither Fish nor Fowl: An Overview of the Big-Three Government-Sponsored Enterprises in the U.S. Housing Finance Markets" by Mises Institute adjunct scholar John Cochran and Catherine England. Among these benefits:
Lines of credit with the US Treasury. Fannie and Freddie may borrow up to $2.25 billion each from the US Treasury, and the FHLB system enjoys a $4.0 billion line of credit. They have never used these lines, but have fought vigorously to maintain them. The lines surely add to the belief that the US government backs the GSEs.
SEC exemption. The debts issued by the GSEs are exempt from SEC registration and disclosure requirements, which saved them collectively an estimated $236 billion in 2000.
Privileged treatment. While banks face strict limits on the amount they can lend to any one borrower, this regulatory requirement does not apply to GSE debt. Therefore, banks can hold unlimited amounts of GSE debt, and this debt is given favorable treatment in computing compliance with regulatory capital requirements. In addition, the Federal Reserve acts as a transfer agent for all of the GSE debt, just as it does for the US Treasury and for government agencies. These privileges expand the market for GSE debt beyond what it might otherwise be.
Tax exemption. GSEs are exempt from state and local income taxes. Fannie and Freddie also don't pay federal income taxes on their earnings, nor property taxes on any of their offices. Cochran and England maintain that the GSEs saved $1.3 billion in tax exemptions in 2000.
There are other benefits more technical in nature but every bit as real. For all practical purposes, the GSEs are government agencies. In addition to the benefits the GSEs receive, the GSEs have imposed a cost on the market as well. We do not know how the mortgage market might have developed if the GSEs had never been created, nor can we guess what alternative uses the capital invested in the mortgage market might have found and what would have been created instead.
The GSEs' preeminent position in the mortgage markets is fortified by these advantages and has undoubtedly contributed to their growth. And yet, while Raines boasts of his company's impressive earnings track record, and as the GSEs take credit for the fact that 70 percent of Americans own their own homes, there are storm clouds gathering.
For one, Warren Buffett sold his Fannie Mae stake last year, writing in his annual report that "the risk profile had changed." Perhaps he was concerned about Fannie Mae's increasing willingness to undertake riskier activities, such as its entry into the sub-prime mortgage market. Fannie Mae, as well as the other GSEs, are also holding more mortgages than before, thereby taking on more interest rate risk. (A GSE has two options when it acquires mortgages: it can package them together and offer them to investors, guaranteeing the timely payment of principal and interest, while allowing the investors to bear the interest rate risk; or it can hold a mortgage itself, taking on the interest rate risk as well as the credit risk.)
Perhaps Buffett realized the increasing difficulty that Fannie is going to have in meeting its target 15 percent annual earnings growth rate. By virtue of simple mathematics, Fannie and its GSE cohorts will eventually control the entire mortgage market and will then have to expand their charters to go into other lines of business—all the while getting bigger and taking on more risk.
It is interesting to note that the GSEs are among the most leveraged of all US industries. Only federally insured commercial banks and savings institutions exceed their debt ratios. Moreover, as Cochran and England point out, if you add back certain off-balance-sheet liabilities (like mortgage-backed securities which the GSEs guarantee) there is approximately $80.55 of debt for every one dollar of equity in Fannie Mae and $64.70 in debt for every one dollar of equity in Freddie Mac.
The fact that the market implies that GSE obligations are backed by the US government only adds to their ability to further leverage their assets. Perversely, as Cochran and England note, "the ambiguous nature of the GSEs' relationship to the government may reverse customary market incentives. In sharp contrast to the concerns that arise when a private corporation increases its outstanding debt, investors in GSE debt could expect that the more debt Fannie Mae has outstanding, the less likely the government will be to allow it to default. Some investors may thus interpret increased GSE debt as embodying less risk rather than more."
The risk to the GSEs is that an economic downturn results in falling home prices, increasing delinquency rates and thus leading to loan losses. With the GSEs' high leverage, it won't take much in the way of losses to cause some significant damage to their financial health. As James Grant recently observed, "Ignorance about tomorrow is a constant of human affairs. Submission to this truth is what's variable. In finance, submission entails a healthy fear of leverage." The GSEs are operating as if the future is certain and prosperous.
An explosive concoction has been created with the GSEs. The GSEs have increasingly dangerous levels of debt, coupled with an implicit government guarantee that seems to encourage even more debt. In the case of Fannie and Freddie, they are publicly traded companies accountable to shareholders for delivering earnings growth that is going to be increasingly difficult to deliver as they grow to the limits of their market. Thus, they are faced with the prospect of lower earnings growth or of finding a way to expand into other (riskier) areas of consumer finance—and further spreading the threat of nationalization beyond just the mortgage market.
The only way to correct this problem is the same way all socialistic practices are corrected—the government's involvement must be severed completely. Just because the GSEs have led a charmed life so far is no reason to infer that their future will always be so bright. Socialism is not dead; it is alive in institutions like the GSEs, which are for all practical purposes government agencies.
It has often been said that there are no free lunches. Surely, Americans cannot continue to subsidize (indirectly) mortgage finance without cost. What most Americans cannot see is that such subsidization of the mortgage industry has led to the assumption of a great deal of risk on the part of the taxpayer. The longer the GSEs are able to expand as they have, the more certain it becomes that someday taxpayers will have to bear the cost of such excess. Like Russian roulette, the longer you play, the more certain it becomes that you will bear the risk for playing.
Christopher Mayer is a commercial lender in Maryland (cwmayer@aol.com). Much of the data on the GSEs is taken from "Neither Fish nor Fowl: An Overview of the Big-Three Government Sponsored Enterprises in the U.S. Housing Finance Markets," by Jay Cochran and Catherine England. The report is available at www.mercatus.org.
