Abstract: This paper examines two major forces that may soon increase competition in the U.S. secondary conforming mortgage market: (1) the expansion of Federal Home Loan Bank mortgage purchase programs and (2) the adoption of revised risk-based capital requirements for large U.S. banks (Basel II). The authors argue that this competition is likely to reduce the growth and relative importance of Fannie Mae and Freddie Mac and hence their franchise values and effective capital. Such developments could, in turn, lead to more risky behaviors by these two GSEs. It is this last consequence that warrants greater regulatory awareness.
JEL classification: G21, G28
Key words: government-sponsored enterprises, mortgages, securitization, risk-based capital, moral hazard, charter value
The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) dominate the U.S. secondary market for conforming singlefamily residential mortgages as both investors in and securitizers of these loans. (1) For example, in 2002, these two government-sponsored enterprises (GSEs) acquired the credit risk on $1.5 trillion in conforming mortgages, or 78 percent of the $1.9 trillion in conforming mortgage originations that year. (2) Such activity over the past decade or so has resulted in Fannie Mae and Freddie Mac becoming the second and fourth largest U.S. companies, respectively, when ranked by total assets as of year-end 2002.
As GSEs, Fannie Mae and Freddie Mac have federal charters (3) that include provisions that serve to lower their operating costs directly (e.g., state and local income tax exemptions) as well as create the perception that their obligations have implicit federal backing (due to, among other things, having access to a line of credit with the Treasury). (4) The presence of such federal benefits naturally leads to questions about their purpose, size, and distribution. That is, should the federal government support housing finance through GSEs? and if so, how they should be structured so as to maximize social benefit and minimize taxpayer risk? Indeed, public interest in these issues has recently been heightened in the wake of hedging and accounting travails at Fannie Mae and Freddie Mac (Frame and White, 2004).
Like the mortgage interest deduction and a myriad of other governmental policies, Fannie Mae and Freddie Mac are a mechanism by which the federal government encourages the construction and consumption of housing. (5) While such encouragements do provide benefits for households in their roles as buyers and consumers of housing services, these benefits are not free. The encouragements for housing significantly reduce the resources available for and thus impose costs on the other sectors of the economy (e.g., Mills 1987; Taylor 1998). Further, it's unclear that that federal sponsorship of Fannie Mae and Freddie Mac actually has a material impact on homeownership rates (Feldman, 2003). As a result, Calomiris (2001) and White (2003) argue that Fannie Mae and Freddie Mac should be fully privatized and replaced with targeted explicit subsidies for first-time, low- and moderate-income homebuyers. Such subsidies, the authors argue, would be more effective in dealing with the genuine positive externality that accompanies home ownership and would be less distortionary.
The size of Fannie Mae's and Freddie Mac's obligations raises questions about the extent of potential taxpayer liability, systemic risk exposure, and the appropriate safety and soundness regulatory regime for GSEs. As of year-end 2002, Fannie Mae had total assets totaling almost $890 billion and net off-balance sheet mortgage guarantees of over $1.0 trillion, while Freddie Mac had about $720 billion in total assets and net off-balance-sheet mortgage guarantees of over $740 billion. (6) Furthermore, both of these enterprises are highly leveraged, with ratios of total equity capital to total assets of 3. …