Stephen Moore
Adjunct Fellow
The Cato Institute

Statement before the
Committee on Banking and Financial Services
Subcommittee on Capital Markets

On:
Reform of the GSEs

September 6, 2000

Executive Summary

I wish to thank Congressman Richard Baker for the opportunity to give my views before the Banking Committee on GSE reform and particular on the legislation H.R. 3703 that he has sponsored. Although we do not endorse or oppose congressional legislation at the Cato Institute, I strongly support many of the reform ideas imbedded in that proposal.

I am particularly supportive of the idea of eliminating Fannie Mae and Freddie Mac’s line of credit with the federal treasury. You will see at the end of this testimony that this is a longstanding reform that I have been pushing. I also have long been an advocate of greater oversight of the GSEs particularly with respect to new markets that the GSEs intend to penetrate. I share Congressman Baker’s concern that the GSEs are exposing the taxpayers to increasing risk and are engaged in a financial dangerous mission creep.

At the end of this statement I provide a list of desirable GSE reforms from the standpoint of protecting taxpayers from undue risk. Ultimately, I believe that the GSEs should be privatized so that they compete with private banks and other financial intermediaries on a level playing field.

Introduction

Stripping the federal government links to the two largest Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, would reduce a multi-trillion dollar future taxpayer liability and spur innovation and competitive behavior in the secondary mortgage market. It would also bring a halt to what has become the greatest threat to the U.S. capital markets today: the unrestrained growth of these quasi-governmental institutions. If these GSEs were to fail, the taxpayers could be facing a $1.4 trillion bail-out. Moreover, there is increasing risk that if Fannie Mae gets in financial trouble, it could create a contagion effect, spread rapidly throughout the banking system. It is precisely at a time when financial markets are strong and resilient that Congress should de-nationalize the GSEs.

The duopolistic structure established by Congress in the secondary mortgage market may have once served a public interest in a bygone era; today, it is contrary to the public interest. In today’s mature financial industry the benefits of this privileged status primarily enrich the shareholders, the workers, and the lobbying industry that protects its federal linkage.

Fannie Mae and Freddie Mac are entirely unique enterprises in America. There is no other organization that shares their quasi-public, quasi-private status. As such, no one can decide for sure, not even they themselves, whether these are public or private entities. And so they enjoy the best of both worlds. They have an umbilical cord to government, which effectively prices potential private competitors out of the market. At the same time, they receive all of the upside benefits of a private corporation: high salaries, a valuable traded stock, the ability to lobby for more. From the standpoint of the taxpayer and the housing market: this is the worst of all worlds. The risks of Fannie and Freddie-which are mounting each day and could reach $3 trillion by 2003--are borne by the taxpayers whilst the benefits confer to private shareholders. This isn’t just an unjustified transfer of wealth from the one group to the other. It is a formula for mischief and even unprecedented financial losses. Fannie Mae’s activities have already s expanded well beyond its original charter. It has become an 800 pound gorilla in the housing marketplace, leverage its lower borrowing costs to squash competitors. In fact, one could make a strong case that Fannie Mae and Freddie Mac, because of their financing advantage, have engaged in far more predatory monopolistic behavior than the Justice Department’s adversary, Microsoft.

It is time to level the playing field in the secondary mortgage market and that can be achieved with minimal disruption to the housing markets and with little negative impact on shareholders by gradually stripping Fannie and Freddie of their federal security blanket. This paper discusses why Congress must de-nationalize the GSEs and how this end result might be achieved.

The Dubious Role of the GSEs

Fannie Mae and Freddie Mac purchase and securitize hundreds of billions of dollars of home mortgages each year. They were established by the federal government to foster a viable and financially secure secondary mortgage market. According to a recent report by Peter Wallison and Bert Ely by the American Enterprise Institute, by 2003 Fannie and Freddie together will bear the risk of some $3 trillion of home mortgages, making these two entities among the largest financial institutions in the world. These two GSEs have roughly quadrupled in assets, liabilities and profitability over the past decade. They prosper largely because they alone enjoy a number of federal benefits. These include a $2.25 billion line of credit with the federal treasury; exemption from state and local taxes; exemption from SEC reporting requirements; and special governmental status for its debt securities, including eligibility for open market transactions by the Federal Reserve Board. These connections to the federal government confer upon Fannie and Freddie an implicit federal guarantee on its debt. As such Fannie and Freddie’s borrowing costs are estimated to be 30 - 50 basis points lower than that of private mortgage lenders. (Earlier this year the spread between corporate triple A debt and Fannie Mae debt was 38 basis points.) All told the total federal subsidy to Fannie and Freddie each year is estimated at $6 to $7 billion a year by the Congressional Budget Office. An estimated 40 percent of the profits of Fannie Mae and Freddie Mac are due to these lower borrowing costs.

The obvious question is: So what? To listen to Fannie and Freddie’s supporters tell the story, this is a win-win for everyone. Homeowners are happy: lower mortgage interest rates. Shareholders are very happy: risk free profits. Congressmen are happy: campaign contributions. Special interest groups are happy: Fannie’s Foundation gives away millions of dollars a year to shrewdly buy the silence of potential political adversaries.

The Economic Costs of the GSEs

Alas, these benefits are not costless. As a longtime analyst of the Federal budget, I am convinced that the unrestrained growth of the GSEs is one of the most economically dangerous developments in our financial markets. Yet almost no one is paying attention. Fannie Mae and Freddie Mac impose an invisible toll on the economy and that toll is borne partially by taxpayers in the form of absorbing risk and partially by the U.S. economy as a whole through a suboptimal allocation of capital. Below I describe this toll in greater detail.

1) The GSEs no longer serve a public purpose.

The mortgage GSEs proudly tout their public-spirited mission, which is to "help more families achieve the American dream of home ownership." But there is increasing evidence that a huge share of the subsidies are not actually accomplishing those objectives. The Congressional Budget Office reports that "as a means of funneling federal subsidies to home buyers, the GSEs are a spongy conduit-soaking up nearly $1 for every $2 delivered."

At least one-third to one-half of the $6 billion in taxpayer support the GSEs receive each year accrue not to homeowners, but to the shareholders, the workers, developers and realtors. This represents a $2 - $3 billion annual income transfer from taxpayers to Fannie Mae shareholders. Also, some of the benefits aare absorbed in munificent salaries of Fannie Mae and Freddie Mac executives. (The president of Fannie Mae, Franklin Raines, makes $8 million a year, 20 times more than the President of the United States.) We could privatize the GSEs and still provide the same level of home ownership incentives at a fraction of the cost, as I will explain below.

2) GSE’s are a ticking time bomb that could suddenly explode in the taxpayers’ laps.

No one doubts that the GSEs, if in financial trouble, would be bailed out by the federal government. In the early 1980s Fannie Mae lost several hundred million dollars and was brought to the brink of financial collapse until federal regulatory forbearance rescued the GSE. The farm credit system was bailed out when it suffered losses in the 1980s as well. This is precisely why the securities of the GSEs carry a lower interest rate. In fact, even Fannie Mae itself has been describing its securities as essentially "risk free." In recent months Fannie has tried to get Wall Street to substitute their securities for T-bills, as a result of the reduced number of auctions of new federal debt given budget surpluses. These securities could only genuinely be risk-free if they carried with them a promise to repay by the federal government-that is, the full faith and credit of the United States Government.

The debt issued by Fannie and Freddie does not officially carry behind it the full faith and credit of the United States government. Moreover, the debt of the housing GSEs is backed with the collateral of home mortgages. Yet every additional dollar of Fannie and Freddie debt imposes future potential burdens on taxpayers and increases federal indebtedness. The implicit federal guarantee on Fannie and Freddie debt means that they are implicitly backed on the basis of the unlimited taxing authority of Uncle Sam. If there is a downturn in the housing market, mortgage delinquencies and foreclosures would soar, housing values would fall, and Fannie and Freddie could sustain huge losses. If the federal debt is undesirable because it imposes financial costs on future generations, then Fannie Mae and Freddie Mac’s mounting debt obligations are undesirable for similar reasons.

Let us now examine just how much GSE debt is outstanding. Here we have one of the greatest stories never told. At the very time that Congress and the White House have adopted a fiscal policy predicated on debt retirement, the GSEs are taking on record amounts of new debt. By the end of this year the federal government will have retired nearly $400 billion in debt since the balanced budget was achieved. Very few policy makers realize that for virtually every dollar of debt that has been retired over the past 3 years in Treasury securities, the GSEs have taken on an additional dollar of debt. For example, in 1999, the federal debt was reduced by about $125 billion while the GSEs increased their net debt by $120 billion. The total level of direct and indirect liabilities of the government has not been reduced at all thanks to the expansive lending and borrowing by the GSEs.

Figure 1 compares the trend in the federal debt held by the public versus the trend in GSE debt. The Figure demonstrates a frightening fact about the housing GSEs: by 2003 the GSEs will hold just over $1.5 trillion of debt. By 2004-5 the GSEs debt will be up to almost $3 trillion and is projected to the for the first time ever be larger than the entire publicly held national debt issued by the U.S. Treasury. These multi-trillion dollar liabilities have been kept invisible from taxpayers and Congress.

At the same time, the GSEs are now increasingly buying back tens of billions of dollars of mortgage backed securities and holding them in portfolio, as shown in Figure 2. This can boost profits but also makes the GSEs much more susceptible to interest rate shifts. Fannie and Freddie now hold about $500 billion in mortgage-backed securities. By 2003 the GSEs will be the ultimate insurer of half the nation’s mortgages.

In sum, GSE expansion is in direct conflict with other national policy objectives. If the goal of the Congress is to reduce taxpayer liabilities for the future, Fannie and Freddie lending must be reined in-and immediately. Because of the rapid GSE expansions of the past several years, we are only treading water when it comes to debt retirement.

3) Fannie Mae and Freddie Mac are forms of corporate welfare for the rich.

No one knows for sure how much the GSE subsidies benefit upper income households, but clearly their lending activities exacerbate the income gap between rich and poor. (The poorest 30 percent of Americans don’t even own their own homes.) The profile of Fannie Mae borrowers tends to be white, and middle or upper class. In today’s housing market, $225,000 homes aren’t typically purchased by poor or working class families. Recent auditing reports indicate that the GSEs are less likely to serve minority homebuyers than private mortgage banks. And studies indicate that lower income homebuyers are less likely to be benefit from Fannie Mae coverage. Hence, to the extent that Fannie and Freddie’s subsidies trickle down to the actual homebuyers, those homebuyers tend not to be poor or even lower-middle class.

If, as most economists agree is the case, some of the benefits of lower mortgage interest rates is captured by the housing industry and the sellers in terms of higher housing prices, then the GSEs do very little to actually promote homeownership. The home buyer gets a lower rate but a higher home price. And some of that benefit is captured by the realtors and the home builders.

Over the years I have found that the loudest and most persistent advocates of Fannie Mae and Freddie Mac have not been homeowner organizations, but the housing industry, which clearly believes that it reaps much of the reward from the existence of these federal subsidies. If Congress is truly dedicated to "attacking corporate welfare," there is no better place to start scaling back subsidies than the GSEs.

4) The GSE are eroding competitive markets in housing finance.

The mortgage agencies have a powerful incentive for expansion. Because no other "private" financial institution can borrow at rates as low as the GSEs, they can take on risks more profitably than its competitors. More importantly, there is a mismatch between the risk and the payoff from GSE debt. Fundamentally, Fannie Mae and Freddie Mac have an incentive to maximize their borrowing because only some portion of the cost is borne by the shareholders-with the remainder spread to taxpayers. The incentive structure is analogous to a person going to Las Vegas and playing the roulette wheel all night under the condition that the government would cover some portion of any losses. In that case the gambler’s incentive might be to maximize his bets. Even bad bets that one would never take on if forced to bear the entire cost of losing, would become attractive under this risk-sharing scheme. Fannie Mae has an incentive to maximize its profits, but its downside risk is partly absorbed by the federal government.

This isn’t just idle theory or speculation. The GSEs have been aggressively expanding in recent years. According to the recent AEI report by Wallison and Ely, GSE debt has soared by more than 7 percent a year since 1995. They predict only a slightly lower growth rate in the five years to come. It is doubtful that the GSEs would be taking on such a Mount Everest sized portfolio of debt if their shareholders bore all of the downside risk themselves.

Even more worrisome is that the GSEs have shown increasing interest in expanding into commercial activities beyond their original charter. They can profitably do so by arbitraging their lower cost of capital. In recent years the GSEs have expressed interest in expanding their activities to include direct mortgage banking, small business lending, purchasing corporate debt and arbitraging the difference between their own and corporate borrowing costs, and entering the jumbo mortgage market by persuading Congress to lift the limits on mortgage size. All of these are bad ideas. As the Economist Magazine recently wrote: of the GSEs: "What the federal mortgage agencies do now is distort the private market. All of this is a perfect example of what people mean when they talk about moral hazard caused by government intervention." Fannie and Freddie are already smothering competition in the secondary mortgage market. With their cost of borrowing advantage, they could, if permitted to, swallow up the mortgage and commercial banking industry as well-thus putting taxpayers at further risk.

Add to this that Fannie Mae and Freddie Mac now have ambitions to replace the shrinking treasury bill market with their own securities, thus becoming the financial world’s risk-free benchmark. If this were permitted to occur, the GSE’s borrowing costs would fall even further, thus increasing their growth potential.

Representative Pete Hokestra (R, MI) is right when he summarizes the state of affairs by noting: "Their [Fannie and Freddie Mac’s] underlying practices may be laying the groundwork for another savings and loan-type crisis." This isn’t just political hyperbole. According to the latest reports of the FDIC, Fannie Mae and Freddie Mac now hold more mortgage risk on their books than the entire Savings and Loan Industry.

5) Fannie Mae and Freddie Mac constitute major threats to the health of the American capital markets.

The Wall Street Journal recently reported that as Fannie and Freddie have grown, they have taken on increasing amounts of risky loans. For example, last year Fannie issued $4 billion of loans on which the borrower put just a 3% percent downpayment on the home. Similarly, a growing share of GSE mortgages require monthly payments by the homeowner that exceed 50 percent of the family’s income. The industry standard is about one-third the family income. In sum in order to find new markets, Fannie and Freddie are moving increasingly into the "sub-prime" market lending to increasingly less creditworthy borrowers.

The GSEs have an abysmally high debt to equity ratio of about 30-1, well above private industry standards. As the Figure shows, the GSEs capital reserves are about one-third that of private banks and thrifts. The Treasury Department has called into question the safety of such a high level of indebtness given the low capital reserves.

For these and other reasons, the GSEs are increasingly regarded as a ticking time bomb in America’s financial system. It is simply financially imprudent to have so much of the nation’s financial security vested in two semi-public, semi-private institutions. According to Michael DeStafano, managing director at Standard & Poors, "If a GSE failed, it would probably take the banking system down with it." Fannie and Freddie are so large today that even if they did not have an implicit federal guarantee, they are probably "too big to allow to fail." Prudent policy would lead policy makers to spread this risk to lower potential taxpayer costs.

STRATEGIES FOR PRIVATIZING FANNIE MAE AND FREDDIE MAC

Rather than allowing the GSEs to expand (in a January 2000 press release Fannie Mae crowed to investors that it has the ability to issue debt in "unlimited quantities"), Congress must begin to devise a plan for shrinking their influence in the housing markets. This could be done gradually over many years, but the important objective is to signal to investors that Fannie Mae and Freddie Mac’s direct ties to the federal government will be severed over time. A weaning process seems the most promising strategy.

A formal privatization of Fannie and Freddie may be desirable, but also politically unrealistic given the political clout of these institutions. The good news is that a fully and formal privatization may not be required. What may be politically achievable would be a series of small steps that would de facto privatize these GSEs. Below I discuss what options should be considered:

1) Arguably the most efficient means of "privatizing" Fannie Mae and Freddie Mac is to peel away their federal benefits. This process should begin by eliminating the GSE’s $2.25 billion line of credit with the federal treasury. The GSE’s exemption from state and local taxes should also be lifted. Next the GSE’s exemption from SEC registration requirements (a special privilege worth about $280 million a year to the GSEs) should be lifted. With respect to Fannie Mae and Freddie Mac debt, it should no longer receive preferential treatment over corporate debt from the Treasury and the Federal Reserve Banks. Each of these steps would reduce the aura of government guarantee on the GSE securities. The interest rate on Fannie and Freddie debt could be expected to rise, thus narrowing the comparative advantage the GSEs have over potential private sector rivals.

A few years ago this proposal may have seemed a total political nonstarter. Not anymore. On March 23^rd Gary Gensler of the Treasury Department proposed before the House Banking Committee to strip away certain key subsidies, including the line of credit with the Treasury. "We believe," testified Gensler, " that Congress should seriously consider the best way to repeal such policies [GSE special subsidies], including a sufficient transition period to prevent any market disruption." Interestingly, the market response to this proposal was to immediately widen the spread between Treasury securities and Fannie Mae debt by about 10 basis points providing a small indication of the value of the GSE’s special ties to the federal government.

2) The Congressional Budget Office has suggested imposition of a "user fee" of 10 to 20 basis points on GSE debt to level the playing field between Fannie and its competitors. The user fee is a partial payment for the implicit guarantee it receives from Uncle Sam. The rationale behind such a fee is that since taxpayers are bearing an implicit risk on Fannie Mae activities, it is reasonable that the federal government recoup fees to pay for that assumption of that risk. The main advantage of such a fee is that it would again help level the playing field between Fannie Mae and its fully private competitors - thus fostering greater innovation and improving customer service in the housing finance market. If a fee is collected, it should be accompanied by a corresponding reduction in taxes elsewhere.

3) Shut down Fannie Mae’s political activities. Entities that receive government subsidies should not be permitted to lobby. The system as it is currently designed bestows a billion dollars of government benefits upon Fannie each year and then allows a portion of that money to be used by Fannie, its lobbyists, and its foundation to politically agitate for more federal dollars or at least to preserve the fortress of benefits that it now receives. In 1997 Fannie Mae spent $5 million on in-house lobbying and close to $1 million in contracts with outside K Street lobbying firms. According to Banking Committee Chairman Jim Leach: "GSEs spend more time, effort and money establishing good relations with Congress…than any other institution in the country." In fact he argues they have more influence on Capitol Hill than all the banks put together.

Fannie’s lobbying activities are contrary to good government-they permit Fannie to use its federal financing advantages to help finance its Washington political activities. Its $350 million "charitable foundation, empowers Fannie Mae to buy the silence of its potential political adversaries. Charles Miller of the Center for Public Integrity recently began a study on Fannie Mae and he told the Congressional Quarterly that "we had folks who would only meet us in strange places, like parking garages." The Foundation should be liquidated immediately.

4) Lower the ceiling on Fannie Mae mortgages from $252,000 to the median home price. One of the original justifications for Fannie Mae and Freddie Mac was to build institutions that would better serve qualifying low and moderate income first time home buyers. Not too many Americans pay $250,000 for their first home purchase. The scale of Fannie Mae’s activities in the housing finance markets could be reasonably curtailed by limiting eligibility of mortgages to no more than the median home price in an area. This would force the GSEs away from the mission-drift that has characterized their behavior over recent years, and would impel these organizations to refocus their energies on lower income homebuyers.

5) Impose a congressional annual cap on GSE borrowing. GSE debt has skyrocketed in recent years virtually unbeknownst to Congress. The accountability has been virtually nonexistent. Congress should be required each year to approve a debt ceiling for the GSEs, just as the federal debt is capped. For Fannie Mae and Freddie Mac to exceed this annual borrowing cap should require a formal vote of Congress. The federal government’s policy of debt retirement is being thwarted by the GSEs. It is doubtful that if Congress took its oversight responsibilities seriously that it would allow GSE debt to mount as it has. According to the U.S. General Accounting Office, if there were a financial crisis in the U.S., a failure of the GSEs could cost taxpayers up to $1.4 trillion in bail-out costs.

6) Increase the equity requirements of the GSEs. This would provide an extra layer of taxpayer protection against potential future bailouts. The goal should be to move the capital requirement in line with its private competitors.

7) If the real goal is to promote homeownership we must acknowledge how inefficient a system the GSEs are for achieving that goal. This is trickle down housing policy. The bulk of the Fannie Mae subsidies are captured by its shareholders, its workers, and are capitalized into the price of homes, thus benefiting developers and realtors. We ought to abolish Fannie Mae and Freddie Mac subsidies (and the FHA, as well), and use the budgetary savings to simply create a fist-time home-buyer income tax credit. This would target the funding to the clientele for which it is allegedly intended.

Thank you again for the opportunity to express my views on this vitally important financial issue.