Fannie Mae, Freddie Mac, and Feddie Sue: What Should We Do with Them?

Mortgage Intermediation

Mortgage intermediation is an important and legitimate business, much like grocery intermediation: In theory, urban consumers could drive to the country to buy groceries directly from farmers, or farmers could go door to door selling produce, but in practice it’s usually more convenient if farmers sell their products wholesale to intermediaries who ultimately remarket it to consumers.

Similarly, workers who are saving for retirement could in theory lend directly to young homebuyers. But in practice it is more convenient for savers to lend to intermediaries who ultimately relend to homebuyers. These intermediaries can absorb individual differences in timing and quantity, serve as credit-evaluation specialists, diversify default risk, and bear most of the residual risk with their shareholder equity.

But just because mortgage intermediation is an important business does not imply that the government should run it or sponsor it, any more than the government should run or sponsor the grocery stores. We expect the government to protect us from fraud and food poisoning, but that does not require the government to run either industry.

The intrinsic problem with the two pre-2008 giant mortgage intermediaries Fannie Mae and Freddie Mac was not their size or that they intermediated mortgages, but rather the fact that they were Government Sponsored Enterprises (GSEs). Although they were profit-seeking corporations with private shareholders, their GSE status gave them special exemptions from state and local taxes, exemption from SEC oversight and normal bankruptcy rules, a small but extraordinary line of credit with the Treasury, and a widespread assumption that their debt would receive a taxpayer bailout in the event of trouble.

One Cheer for Fannie and Freddie

Fannie and Freddie were in fact works of genius in comparison to the old Savings and Loan industry, much of which went belly-up in the 1980s: Long-term amortized loans are the ideal way to finance durable houses, but the S&Ls made the mistake (with an effective subsidy from the now-defunct Federal Savings and Loan Insurance Corporation) of financing these loans with zero-maturity savings accounts. After deposit interest rates persistently rose throughout the 1960s and 70s, most S&Ls found themselves with locked-in losses that made it only a matter of time until they became insolvent. By 1980, economist Edward Kane showed that the industry was already deeply underwater in economic terms. Lax regulatory forbearance allowed these “Zombie Thrifts,” as Kane called them, to get even deeper in trouble throughout the 80s, until they and FSLIC were finally shut down with a taxpayer bailout in 1989.

For all their faults, Fannie and Freddie avoided the fundamental error of the S&L industry, by instead financing long-term mortgages with comparably long-term bonds. In the 1990s, they took over much of the market share left vacant by the failed S&Ls.

Why Fannie and Freddie Failed

Nevertheless, Fannie and Freddie did ultimately fail on a spectacular scale, for a number of inter-related reasons:

First, they were operating with razor-thin capital margins that would have prevented fully private firms from borrowing money on reasonable terms. Their debt was explicitly not government guaranteed, but it did have an “implicit” guarantee based on the assumption that they would ultimately be bailed out, as ultimately proved to be true. This “implicit guarantee” allowed them to borrow money at rates only a little higher than the Treasury paid, and far less than they would have had to pay given their risks and capital. With little “skin in the game” and ready access to funds, they had little incentive not to take undue risks.

Second, they were pressured by Congress to waive traditional underwriting standards on loans they bought and guaranteed, both in terms of borrower equity and payment-to-income ratios: In 2000, the median down payment on new home loans was 20%, but by 2006 this was down to barely 5%. “Liar loans” with sketchy appraisals and income documentation, and “no-doc” loans with no documentation at all became endemic. The result was the mortgage-fueled housing bubble and ultimate financial collapse of 2007-2008. Without their GSE status and “implicit guarantees,” F&F could never have funded this disastrous bubble.

And third, their captive regulars turned a blind eye to accounting irregularities that SEC-regulated firms would never have gotten away with. An Oct. 4, 2004, Wall St. Journal editorial compared their accounting creativity to that of Enron. The 2007 OFHEO Report to Congress could not say what book assets Fannie had for any year since 2004. The SEC is undoubtedly far from perfect, but at least it insists that the firms it regulates file annual financial reports!

The Solution for Fannie and Freddie

The solution, then, is not to get rid of Fannie and Freddie or to deliberately phase them out, but rather to strip them of their GSE status and to subject them to normal bankruptcy proceedings. It is often the case that even failed firms are worth more to their creditors alive than dead, and this is probably the case for F&F. In stripping them of their GSE status, Congress should therefore subject them to normal bankruptcy law, including the option of Chapter 11 reorganization.

I would envision that such a Chapter 11 procedure would shred the old F&F common stock, mark their debts down until they are clearly adequately solvent, and then give the creditors new common stock. The creditors could turn around and sell this stock, partially but equitably compensating them for their haircut.

Unfortunately, a large portion of F&F’s debt and stock is now owned by the Treasury and/or the Federal Reserve, as a consequence of the 2008 bailouts. The F&F bailout should never have taken place, but given that it did, this is milk that has already been spilled. Reorganizing F&F will merely make explicit losses that have already been inflicted on the US taxpayers, either directly through the Treasury or indirectly through the Fed.

What we need is not to get rid of bond-based mortgage intermediaries like Fannie and Freddie, but rather more of them, only without the GSE status. If state and local taxes and SEC oversight are unreasonable burdens, then all businesses should be exempted from them. If not, mortgage intermediaries should be subject to the same tax and regulatory burdens as any other firm.

Of course, bankruptcies would serious impair F&F’s reputations. Perhaps they would recover, or perhaps they would just wither away, but this decision should be left up to the market.

Feddie Sue

Prior to 2008, the two giant government-sponsored mortgage intermediaries were Fannie Mae and Freddie Mac. Since 2008, however, a third entrant has appeared on the scene.

Before 2008, the Federal Reserve System acted as a traditional central bank, primarily buying Treasury securities with newly printed money and bank required reserve deposits. Since 2008, however, the Bernanke Fed has in addition acquired approximately $1.3 trillion of mortgage-backed securities and GSE bonds. It is financing this position with zero-maturity bank excess reserve deposits on which it must pay a competitive rate of interest, just like the traditional S&L.

I have dubbed this new function of the Fed the Bernanke Federal Savings and Loan Association, or Feddie Sue for short. Currently short-term rates are near 0, but when they inevitably rise, the Fed’s new Feddie Sue function will be in the same position the S&Ls found themselves in 1980, with locked-in accounting losses until the fixed-rate mortgages mature. This will reduce the profits the Fed is required to turn over to the Treasury, and could even turn them negative.

The Fed should unwind this dangerously risky position forthwith. At the very minimum, it should not reinvest payments on these mortgage-based securities in yet more mortgages, but rather should pay off the dangerous bank excess reserves as promptly as possible. There is no reason the Fed should be in the mortgage intermediation business, and in particular it should not be repeating the mistakes of the old S&L industry by borrowing short and lending long.

Home Debtorship vs. Home Ownership

One particularly subtle policy contributor to the severity of the housing finance crisis has been the deductibility of home mortgage interest. This deduction at once discourages home-equity accumulation, and makes the financial sector unnaturally large.

In the absence of this distortion, young homebuyers would at first put their long-term savings into their home equity by paying down their mortgages as fast as possible. Only after they were free of the burden of a house payment would they would they turn to financial instruments to finance the remainder of their retirement.

But with this tax distortion, the “smart” strategy has been to keep home equity as small as possible, and instead to place any savings in financial instruments. This has made mortgages more likely to default, and has also artificially bloated both the financial intermediation sector and Wall Street. A smaller financial sector will not prevent future financial crises, but at least it will make them proportionately smaller.

The mortgage interest deduction, like other government mortgage interventions, is commonly defended on the grounds that it encourages “home ownership.” But in fact, a fair definition of a “home owner” is one who has a 50% or greater equity stake in one’s home. Those with less than 50% equity are in fact home debtors. In truth, encouraging homebuyers to borrow as much as possible and then repay as slowly as possible amounts to fostering home debtorship, not “home ownership.”

A top priority for housing finance reform should be to phase out the home interest deduction—over, say, 5 or 10 years, to soften the impact. At the same time, personal income tax rates should be reduced across the board in a revenue-neutral manner. Because the lower marginal tax rates will increase the incentive to earn taxable income, tax revenues could actually increase from this reform.

Two Additional Recommendations for Mortgage Intermediation

Home mortgages typically entitle the borrower to prepay the balance with no penalty other than the loss of up-front “points.” Borrowers can and should be paying a premium for this prepayment or “call” option. In order to protect themselves from losses from refinancings when interest rates fall, mortgage intermediaries can and should include comparable call provisions in the bonds they issue. Of course they will have to pay investors a premium for this call option, but they’ll be compensated by the comparable premium they receive from borrowers.

According to the Wall St. Journal (Editorial, 9/23/2003), Fannie Mae was in the habit of instead engaging in reverse interest-rate-risk by funding callable mortgages with cheap, non-callable debt. Even if the expected maturities matched, protecting them from rising interest rates, this would have exposed them to potential losses from falling interest rates. It’s not clear how big a factor this was in its ultimate downfall, but it could have been a contribution. Rating agencies should take this risk into account, along with underwriting standards, when they rate the debt of the newly privatized mortgage intermediaries.

And finally, although houses are very durable assets that warrant relatively long-term financing, the traditional 30-year mortgage has very slow amortization during its first decade, which may not be enough to absorb poor maintenance or negative housing shocks. And although most are repaid before maturity, those that survive past 20 years may become relatively costly to administer, since the inflation-adjusted balance may have become quite small.

Today, borrowers take 20-year or even 15-year maturities in stride in exchange for reduced interest rates. I would therefore recommend to the newly privatized financial intermediaries that they restrict their maximum maturity to 20 years. But of course they would be free to take or leave this advice.