Franklin Raines, speaking for the Bush administration, says that he is in the "American Dream business."1 Raines is chairman and CEO of Fannie Mae, a corporation whose mission is "to tear down barriers, lower costs, and increase the opportunities for homeownership and affordable rental housing for all Americans. Because having a safe place to call home strengthens families, communities, and our nation as a whole."2
A prolific speaker, Raines has been touring the country to present his view that Fannie is helping to fulfill the American dream for millions of citizens. And as if that were not enough to justify Fannie’s existence, Raines cites Joseph Schumpeter,3 chaos theory4 , and the work of the Peruvian economist Hernando de Soto to further argue that Fannie is strengthening capital markets and promoting entrepreneurship.
But can Fannie Mae really make housing more affordable for all Americans, without imposing ruinous costs on some?
Fannie: The Mortgage Behemoth
Fannie Mae and Freddie Mac are quasi-private firms chartered by Congress to create and provide liquidity in secondary mortgage markets. They are known as government-sponsored enterprises (GSEs), a moniker that reflects their privately owned but government-chartered and -regulated status. Together, they purchase, retain, or guarantee more than 70 percent of the conforming mortgage market.5
Mortgages are originated by retail institutions such as banks. Fannie purchases standardized ("conforming") mortgages from the originators. Fannie then either holds the mortgages or packages them together as securities, called mortgage-backed securities (MBSs or "agency debt") and sells those securities on credit markets. Many of them are purchased by money market funds.
In a free-market economy with a sound monetary system, all funds that are loaned to borrowers were necessarily saved by savers somewhere else in the economy. The act of saving is the deferral of a consumption opportunity from the present to the future. Savers require an interest payment for this sacrifice. Borrowers take on the obligation to pay interest because they value the opportunity to fund present consumption more highly.
In every credit transaction, there is a risk that the borrower may not have sufficient income to fund the debt obligations. This default risk must be borne by some combination of the two parties in the transaction. The borrower can put up collateral, or the lender can charge a higher interest rate to compensate for the risk. Private lenders that are risking their own capital have a natural caution about the level of risk that they are willing to assume.
Fannie is a financial intermediary: It borrows from some and lends to others. However, Fannie’s regulatory status gives it a number of special privileges not available to private firms operating in the credit markets. In a free market, financial intermediation is a good. Intermediaries perform the valuable service of bridging potential buyers and sellers.
But GSEs are not a free-market intermediary. Unlike private transactions in which the risk is shared by agreement among the parties to the transaction, GSEs silently transfer default risk (beyond their own meager capital reserves) to the taxpayer through an implied government guarantee.
But that’s not all. For other reasons, agency debt is more attractive than debt issued by private corporations. Because it has transferred some of the default risk to third parties, Fannie is less cautious in evaluating the default risk of borrowers than a private firm risking its own capital would be. Another factor is that GSE securities are accorded preferential treatment in the calculation of bank reserves, so they can be purchased in many cases where private MBS or other forms of debt could not. And finally, the GSEs themselves are exempt from federal and state income taxes.
Reserves are held by lenders as a cushion against default by some fraction of their borrowers. A desire to maintain a certain reserve ratio limits the amount of credit a lender can issue. Fannie’s costs are reduced because its own capital reserve requirements are lower than for comparable private firms, i.e., it is able to issue more credit with the same amount of reserves.
Fannie’s monopoly privileges have given it an ever-increasing share of the secondary conforming mortgage market, and it currently is seeking to expand into other parts of the mortgage market.
The Demand-Side Case
In his speech to the Securities Industry Association late last year, Raines breaks down the case for subsidizing the flow of funds into the housing market into two components: supply and demand. On the demand side, he cites a multitude of trends driving increasing demand for what he calls "housing investment and mortgage credit": population growth, the growth in home ownership rates, the maturing of the population into home ownership years, increasing house prices, the trend toward larger houses with more amenities, and the decreasing equity ratios of home loans.6
Raines combines these factors to calculate the total "demand" for residential real estate investment of $11 trillion to $14 trillion over the next decade. This is the amount that borrowers will need to borrow, given Raines’s assumptions of price appreciation. Here, Raines raises the specter of Yogi Berra-nomics,7 a condition in which homes are so expensive that no one can afford to buy one. He says, "From the demand side, we know that consumers will need twice the mortgage capital to own their homes. And if the supply of capital falls short of demand, it would only drive up the cost of housing of all types."
An Affordable Housing Bubble
Fannie gives banks the ability to lend potential home buyers funds that they could not otherwise qualify for, with which they may purchase a home that they could not otherwise afford. For example, the Wall Street Journal reports that home loan mortgage payments as a percentage of disposable income are at record levels due to "changes in mortgage underwriting standards," and that the average down payment has declined over the last decade from 10 percent to 3 percent, with zero down payments not uncommon.8 Fannie claims that it is using its regulatory privilege to decrease the cost of the credit to home buyers.
But does this make housing more affordable? The housing market will respond to an increase in demand by some combination of increasing supply and/or increasing prices. Research by Bert Ely, author of a study on the GSEs for the American Enterprise Institute, has suggested that subsidizing mortgage loans does not do much, if anything, to make housing more affordable because most of the subsidy goes into price increases rather than supply increases. His research shows that only a small increase in home prices is necessary to fully capitalize the interest rate subsidy.9
Ely’s research also indicates that a portion of the demand subsidy goes toward an increase in the size of homes.10 Ironically, it is this increase in home size that Raines cites as another factor driving demand for its lending activities.
The GSEs have linked home prices to the market for risk-free debt securities. Domestic and foreign buyers purchase these securities. In fact, they are a significant fraction of the capital accounts surplus funding U.S. the trade deficit. Fannie’s continued ability to find buyers for riskless debt securities allows it to create what appears to be an increasing demand for housing by magnifying the amount of systemic risk.
Most home owners are completely unaware of this process, believing instead that their home prices are driven by the factors similar to those Raines cites, and that home prices move in only the upward direction. This process is not unlike the way small investors approached the stock market during the stock market bubble.
The fallacy of Raines's demand-side case for subsidized mortgage credit is that when a demand subsidy exists, home prices are partially a byproduct of the demand subsidy. Raines's claim that Fannie is simply stepping in the gap to supply much-needed credit is disingenuous. Increasing home prices are partially a consequence of Fannie’s credit subsidy. Of Raines's list of so-called drivers of credit demand, most are side effects of the leverage and declining credit quality that Fannie has created.
If Fannie’s policies enable some buyers to obtain loans credit that they could not otherwise afford, then for them, the cost of buying a home will be lower--"more affordable." As Raines has claimed in one of his speeches, "The suggestion that too much capital is going into housing is not new. We heard it a lot in the beginning of the 1990s. Fortunately for the 10 million families who became homeowners during this decade, the theory did not get much traction."11
It is not surprising that the recipients of a subsidy were pleased with the result: demand for a free good always exceeds supply. The borrowers, the banks, and Fannie’s shareholders are quite happy with this arrangement. Taxpayers will probably remain unaware of their obligation until the bill becomes due. Were interest rates to rise, housing prices to turn down, or the ratio of mortgage loan defaults to increase beyond Fannie’s reserves, a taxpayer bailout reminiscent of the S&L bailout would probably be called for by holders of GSE debt.
The Supply-Side Case for Affordable Housing
Raines is aware of the argument that supplying subsidized funds to housing diverts resources from other, more productive uses. For those skeptics who aren’t convinced that funding a housing bubble by transferring the risk of Fannie’s credit pyramid to the taxpayer is a good thing, Raines has been reading Peruvian economist Hernando de Soto’s book, The Mystery of Capital.
De Soto writes that, "the single most important source of funds for new businesses in the United States is a mortgage on the entrepreneur's house. These assets can also provide a link to the owner's credit history, an accountable address for the collection of debts and taxes, the basis for the creation of reliable and universal public utilities, and a foundation for the creation of securities (like mortgage-backed bonds) that can then be rediscounted and sold in secondary markets. By this process the West injects life into assets and makes them generate capital."
When nations don't have this "representational process," he says, their assets--including their homes--become what he calls "dead capital."
And therein lies the supply-side argument for more capital flowing into housing. Housing in America generates capital. It creates and broadens the distribution of wealth--not only the wealth of individuals, but also the potential wealth of nations. And as a capitalist, I believe that is a good thing.12
Raines has seriously misunderstood de Soto’s argument. De Soto is making a case for the importance of enforceable property titles. Without property titles, there will be individuals who have funds that they would be willing to lend, for some rate of interest. There will be others who would like to borrow in order to start or expand a business.
The entrepreneur always faces a risk of business failure.The borrower could reduce this risk to the lender’s principal by putting up some of his own property as collateral. The lender will be unwilling to accept this type of collateral if the property does not have a clear title because such a contract would not be enforceable. Even if the aspiring entrepreneur wanted to sell his possessions outright to raise the funds, he would have a harder time selling without transferable titles. Without clear titles, credit transactions will only occur where there is a high degree of personal trust between the parties. In the informal economy that de Soto has studied, possession may be the only form of title that exists.
De Soto’s work shows that when a country establishes a system of enforceable and transferable titles, there is a tremendous benefit: credit transactions between unrelated individuals become much less risky. This opens the possibility for many borrowers and lenders to participate in mutually beneficial exchanges, and eventually, for anonymous exchanges through capital markets. Thus potential entrepreneurs with some assets to their name can more easily raise funds.
Raines completely misunderstands that de Soto’s thesis is a point about the legal system, not an argument for a greater quantity of funds to be allocated to any particular sector of the economy. Because the United States already has a system of enforceable and transferable property titles to real estate, this systemic benefit has already been realized here and is no longer available. All homes in the U.S. already have clear and transferable titles attached to them. And there is a well-developed system of title insurance in place to protect against errors in titles or unforeseen claims. Home owners already have the ability to buy and sell their homes or borrow against them. There is no additional systemic benefit to be realized by creating a system of property titles in the U.S.
The use of the term "capital" by both Raines and de Soto is the source of some confusion. From an Austrian perspective, capital (in the economic sense) consists of those goods that figure in the production plans of entrepreneurs.13 Production consists of using the factors--land, labor, and capital--to produce more capital or consumption goods. Capital has value only because of its ability to contribute to the ultimate production of consumption goods. Capital goods are the intermediate products of time-consuming production processes. Some examples of capital goods are factories, machinery, semiconductors, and oil tankers.
In a complex economy, each of the various steps in production processes can be performed by different individuals or firms. Firms base their decisions to produce on anticipation of the value of their product in relation to the final, consumed goods that will be produced. Capital goods have value only because of their contribution to goods that a consumer is willing to pay for.
The creation of capital must be funded out of savings, because those who produce capital goods need to consume something while they are producing something else that is not, itself, for consumption. Savings is the abstention from a possible consumption opportunity. Those who save and invest are transferring their command over consumption goods to the producers of capital goods.
People often use the word capital to refer to money that can be invested in a business venture, or money that changes hands in the markets for capital goods, known as capital markets. While money can be spent to purchase factors of production (of which capital is one), money is not itself capital in the Austrian sense. The term loanable funds is a better way of describing money that a lender is willing to loan to an entrepreneur.
The Confusion of Capital
In the passage that Raines quotes, de Soto is using the term capital to mean any asset that has value. A careful parsing of Raines’s and de Soto’s statements is required to arrive at a consistent understanding. A home is an asset, and it is wealth, but it is not capital in the economic sense; i.e., it is not a good that is an intermediate artifact of a time-consuming production process. Housing is a consumption good. True, it is a durable consumption good, and it may rise in value over time for many reasons, but it is not capital.
De Soto unfortunately uses the term capital to mean credit, or loanable funds. De Soto’s point can be restated:
In an economy without enforceable, transferable property titles, potential entrepreneurs have difficulty borrowing funds because they cannot secure the loans, due to their inability transfer the title.
In an economy with enforceable, transferable property titles, entrepreneurs can use assets as collateral with which to secure loans of loanable funds. The entrepreneur can then use the borrowed funds to purchase or lease land, labor, and capital as part of their production plan.
Raines is claiming that when Fannie provides more loanable funds to home buyers, more capital is created, thereby increasing the scope for entrepreneurship and economic growth. Here, Raines is guilty of confusing loanable funds and capital. Fannie’s subsidies and special privileges allow it to extend credit at a lower price than it otherwise would. This risk-shifting attracts more loanable funds into housing than otherwise would be, but does not increase the amount of real capital in society. No savings has taken place nor have any new capital goods been produced.
If Raines were really interested in increasing the amount of capital, the funds that Fannie loaned to the home buyer could have been loaned to an entrepreneur to fund real investment. If that is the goal, what benefit is there of first loaning the money to a home buyer, who can then borrow against his home? Fannie and other intermediaries may profit from this sequence of exchanges, but that is not to be confused with more savings or the production of more capital goods.
As chronicled by numerous observers of the current financial scene,14 Fannie funding is increasingly used for "cash-out" refinancing and home equity loans, the proceeds of which are spent to pay down credit card debt, or to fund more consumption items. The long-term result of increasing consumption at the expense of savings investment is that capital is consumed without being replaced. An economy with less capital can produce fewer consumption goods. Overall wealth is diminished.
An economy grows, i.e., increases its ability to produce consumption goods, when people save enough to fund the accumulation of more capital. Thus, wealth creation depends on savings. This is the only real way to make most things more affordable for the bulk of the population. Only the accumulation of more capital goods will enable business firms to produce more consumption goods.
Raines may be in a dream business, but the net result of Fannie Mae’s actions in the credit markets is a nightmare of resource misallocation and massive systemic risk.
- 1Quoted from Raines’ biography.
- 2From the Initiatives page
- 3See the speech.
- 4See the speech.
- 5"Critics: Fannie, Freddie Grip Mortgage Market," USA Today, May 21, 2002.
- 6Franklin Raines, speech to the Securities Industry Association, November 8, 2001.
- 7The great Austrian economist Yogi Berra once said: "Nobody goes there anymore; it’s too crowded."
- 8Stretched Buyers Are Pushing Mortgage Levels to New Highs, Wall Street Journal, June 12, 2002.
- 9GSEs of Federal Policy: Public Benefits as Instruments and Public Costs, Bert Ely, pp. 5 and 8. See also Neither Fish nor Fowl: An Overview of the Big-Three Government-Sponsored Enterprises in the U.S. Housing Finance Markets, Jay Cochran III and Catherine England, p. 38.
- 10Ely, p. 9.
- 11Raines, SIA speech.
- 12Raines, SIA speech.
- 13Microfoundations and Macroeconomiocs: An Austrian Perspective, Stephen Horwitz, Routledge (2000), p. 45.
- 14See, for example, Doug Noland’s weekly column, The Credit Bubble Bulletin, on www.PrudentBear.com. See also Jim Puplava’s Financial Sense web site, The Last Wave.