The post was originally published on the R Street Institute website.
Americans have for years been addicted to long-term (that is, 15 to 30-year) fixed-rate residential mortgage loans. We just can’t live without them. The severity of this habit is analogous to a potato-chip addiction: they may not kill you, but they sure don’t make you healthy.
But we didn’t get hooked totally on our own. There were enablers, like the government-sponsored enterprises Fannie Mae and Freddie Mac. It seems like a long time ago, but I once worked for Fannie Mae, from 1988 to 1997. I never made it big; never qualified for the lucrative stock options that made small fortunes for those ranked director and above. But I did learn a few things about how the company operated and its role in the marketplace.
When I came aboard in 1988, Fannie Mae was recovering from the double whammy of severe interest-rate mismatches and credit-quality issues. The focus was to get the company on track for sustained profitability. Fortunately, as a result of the hard work of those in the asset-liability management and credit-policy departments, the company was able to figure out how to manage both its interest rate and credit risks.
Helping considerably was the growth in the market for pass-through securities, fueled in no small part by new techniques to pool such securities and manipulate their cash flows to form the kinds of multiple-tranche securities that Wall Street was delighted to market to investors, as well as to provide a secondary trading market for. There’s nothing like financial engineering, combined with an implied federal government guarantee, to make a lot of people on Wall Street extremely wealthy. This was the sort of “public-private partnership” that we still have much too much of.
As is well-known, the movement from serious losses to sustained profitability was indeed successful for a time, but there was no happy ending. The ultimate collapse was the result of what I see to be four inconvenient truths that must be dealt with before Fannie and Freddie can come out of conservatorship.
The importance of the implied federal guarantee: The implied government backing is what makes Fannie and Freddie securities appealing to investors, not the fixed-rate loans that also back them. Without such a guarantee, there is no huge natural investor base, domestically or overseas, hungering to invest in trillions of dollars of 15 and 30-year fixed-rate residential mortgage loans that have been originated in the United States. It’s also what allows Fannie Mae and Freddie Mac to be profitable, as it significantly reduces the costs of its funding to levels approaching U.S. Treasury rates. It is readily apparent that without a significant federal subsidy, the funding for fixed-rate loans would be radically reduced. This is a sad truth for those who wish to delink Fannie and Freddie from the federal government and then throw them into the competitive marketplace so they can sink or swim. They will sink.
The inadequacy of insurance premiums: If Fannie and Freddie were to pay insurance premiums to the federal government to cover the cost of the implied federal guarantee, those premiums would always be inadequate. As described above, the guarantee is literally what allows Fannie and Freddie to function as providers of enormous volumes of low-cost fixed-rate loans. If the companies were required to pay the true cost of its federal subsidy, the cost of fixed-rate loans would likely rise to levels the average borrower would find intolerable.
Capital levels are not terribly important: Much is made of requiring Fannie and Freddie to have rigorous capital requirements if they were ever to leave conservatorship. But what may seem rigorous to some, will most likely not be rigorous in reality. It is simply the downside of financial institutions that require significant leverage to finance extremely large operations, institutions that include Fannie and Freddie. If they once again suffer credit-quality issues similar to what they faced during the financial crisis, Fannie Mae and Freddie Mac will quickly use up whatever capital they have, throwing the companies back into conservatorship.
The traditional corporate objective does not apply: The traditional argument is that shareholders are the residual interest holders; therefore the objective of a company’s governance should be shareholder wealth maximization. This should lead to wealth creation for the country as a whole. However, given how much residual risk the federal government retains through its implied guarantee of trillions of dollars in Fannie/Freddie securities, it’s hard to make the argument that shareholder wealth maximization should be the corporate objective of the GSEs. Instead, the objective should be to minimize the potential cost to taxpayers, the stakeholders with the most to lose from an unsuccessful Fannie and/or Freddie. This objective of risk minimization instead of wealth maximization supports the argument that the GSEs should not have shareholders, but instead be wholly owned by the federal government, similar to how Ginnie Mae is structured.
History also tells us that Fannie and Freddie should not have shareholder wealth maximization as their corporate objectives. For example, once Fannie achieved sustainable profitability during the time I was employed there, an odd thing happened. The strategy to achieve profitability became one of protecting the franchise. In a nutshell, this meant keeping the administration and Congress off its back. The best way to do that was to focus on the investment and securitization of affordable housing loans, or what are more commonly referred to as subprime loans. Not enough to kill the golden goose, but just enough to keep all the political stakeholders reasonably happy.
Over time, the increased pressure to keep everyone happy resulted in the purchase and securitization of so many subprime mortgage loans that the golden goose was indeed killed. We can never allow these two companies to utilize such a strategy ever again. The easiest way to accomplish this is to restrict ownership to the federal government.
It would be great if we could just let the markets take care of providing us with an adequate amount of fixed-rate loans, but this level of lending would not be politically acceptable. Whatever the efficiency and wealth-creation arguments, that is the reality and the best we can do is to minimize the cost of our addiction.
This can be done by keeping a lid on the size of Fannie and Freddie’s fixed-rate mortgage loan portfolios and their mortgage-backed securities businesses and by charging each institution an acceptable insurance premium to compensate for the federal government’s implied guarantee of their securities. There will always be political pressure to loosen the requirements and allow the federal government to increase its subsidy to the housing-finance sector via Fannie and Freddie. This is the political risk that must be diligently defended against until we can find a way to end our addiction.
Bernard S. Sharfman is Adjunct Professor of Business Law at the George Mason School of Business and an Associate Fellow of the R Street Institute.