The Free Market
The Redistribution of Risk
The Free Market 19, no. 10 (October 2001)
One of Franklin Roosevelt's many schemes to "save capitalism from itself" in the 1930s was the creation of the Federal National Mortgage Association, known today as Fannie Mae. Created in 1938 as part of the Reconstruction Finance Corporation, Fannie Mae's original mandate was to purchase Federal Housing Administration loans.
But, as is the natural propensity of any government entity, Fannie Mae has expanded far beyond its original purpose. It now owns 20 percent of all US mortgages and wields much influence in US financial markets. And it shows no signs of retrenching.
The financial markets classify Fannie Mae and its counterpart Freddie Mac (also known as the Federal Home Loan Mortgage Corporation) as Government Sponsored Enterprises, or GSEs. Both are listed on stock exchanges, although they are exempted from SEC registration. Proponents of Fannie Mae and Freddie Mac claim that the GSEs' functions not only support free-market forces but are downright honorable.
These proponents claim that the GSEs provide the mortgage market with liquidity by purchasing mortgages from their originators in a secondary market. By doing so, GSEs free up cash among a network of twenty_five loan originators, allowing them to underwrite more loans. The result is more Americans realizing "the American Dream" of home ownership. The mortgages are then pooled and repackaged as fixed income securities known as mortgage backed securities (MBSs).
Government chartering of these organizations causes risk to be transferred from GSEs to the unknowing American taxpayer. The taxpayer will bear the full cost of Fannie Mae's risk assumptions in the event of widespread mortgage default. Each individual is burdened enough by trying to pay his own mortgage while government is plundering his paycheck.
The burden of millions of other mortgage payments should not rest on his shoulders as well. Fannie Mae preys on the common American's ignorance of financial markets for its own benefit. This would not be the case if Fannie Mae's government ties were removed and it were forced to take part in true free-market enterprise.
Fannie Mae's estimated $10.9 billion subsidy is not a direct taxpayer subsidy. Participants in financial markets perceive the debt of GSEs to be backed by government (i.e., in the event of a real-estate crisis, the federal government will bail out these organizations). This implicit guarantee allows Fannie and Freddie to secure favorable borrowing rates.
GSEs are exempt from most state and local taxes, and each holds an emergency US Treasury credit line valued at $2.25 billion. Fannie Mae clings like a leech to these subsidies in order to make it difficult for other firms to compete. The result is Fannie Mae's ownership of 20 percent of all US mortgages.
But the real danger of government's protection of Fannie Mae and Freddie Mac is to the American taxpayer. Precedent for a taxpayer bailout has already been set. The Farm Credit System (a Government Sponsored Enterprise), created to provide financing to agricultural America, accumulated losses of over $4.5 billion in the mid-1980s. Congress revised the structure of the FCS and guaranteed an issue of 15-year bonds to cover losses. The US Treasury promised to pay interest on the issue for the first five years and half the interest on the next five years.
A more applicable precedent in predicting government action in the event of widespread mortgage default is the savings and loans crisis of the late 1980s and early 1990s. An increase in the federal insurance of individual savings from $40,000 to $100,000 and a relaxing of government regulation over the credit policies of savings banks sparked an increase in the risk assumed by these thrifts.
The ensuing bailout of the savings and loan industry led to the creation of the Resolution Trust Corporation, an agency anointed with the mandate of rescuing thrifts. By 1996, the RTC was disbanded, and the federal government could claim victory over the mess that it had created. Victory, however, came at a steep cost to the American taxpayer. Uncle Sam reached into the pockets of Americans for a hefty $120 billion as a direct result of the debacle.
The size of Fannie Mae and Freddie Mac (rated the third and fifth largest financial institutions in the United States, respectively, by SNL securities) would place a high degree of pressure on government officials to "solve" any crisis involving these two entities. The consequences of such an action will be the same as past consequences of the government doctoring the ills of the banking industry.
Even Lawrence Summers and Alan Greenspan, hardly opponents of government intervention in financial markets, have been sharp critics of the government's risk redistribution scheme. Former Treasury Secretary Summers directed his efforts toward undermining the implicit guarantee by providing securities market participants with language inserted in the 2000 federal budget that left little to interpretation. His aides were able to insert in the budget that GSEs were "not federally guaranteed."
The words had a severe impact on Fannie Mae's borrowing costs. They skyrocketed, but not for very long. Fannie Mae fought back by increasing campaign contributions and hosting a campaign of its own that allowed politicians to stand on a stage and claim alliance with Fannie Mae. Within months, Fannie Mae's borrowing costs were again lowered and the risk of its borrowing was back in the possession of taxpayers.
Fed Chairman Greenspan wrote in a letter to Louisiana Republican Congressman Richard Baker that "these subsidies have important consequences for the structure and efficiency of the financial markets and the productive allocation of real resources." Greenspan stated: "Subsidies accorded to GSEs are, of necessity, at the expense of other federal or private-sector initiatives and hence are ultimately financed by households, either through taxes or through the reduced accumulation of wealth."
Despite the irony and hypocrisy in Mr. Greenspan's statements, he highlights the misappropriation of financial resources resulting from government subsidies in the mortgage market. Public lending to GSEs at less-than-market rates of interest allows Fannie Mae and Freddie Mac to issue more debt than would have been issued if the two enterprises had not been benefactors of government backing. This essentially redirects capital that would have been allocated to other uses in the private sector. The risks assumed by those private sector uses would have been borne by those involved (i.e., not passed off to innocent bystanders).
If GSE credit policies were not distorted enough by government subsidies, they are sure to decline even further as a result of a June 2001 study conducted by FM Watch (a coalition of financial services and housing-related trade associations that has taken over the leading role of keeping a watchful eye over GSEs)
According to the study, titled "Shuddered Dreams: How Fannie Mae and Freddie Mac Misspend the GSE Housing Subsidy," lower-income minorities, especially African-Americans and Hispanics, have not been getting their fair share of the subsidy pie. In a free market, an enterprise evaluates risk at its peril. In the subsidized mortgage market, risk measurements must be cast aside at the taxpayer's peril in cases where protected classes have been excluded.
The redistribution of risk is as contemptible as the direct redistribution of wealth through taxation. If the past is any indicator of the future, the growing threat of Fannie Mae and Freddie Mac will eventually result in the federal government reaching further into the pockets of Americans to solve a chaotic situation caused by government intrusion in the market.
David Barnes is an investment analyst in Atlanta, Georgia (email@example.com).
Cite This Article
Barnes, David. "The Redistribution of Risk." The Free Market 19, no. 10 (October 2001).