Charter Value, Risk-Taking Incentives, and Emerging Competition for Fannie Mae and Freddie Mac
Frame, W. Scott, White, Lawrence J., Journal of Money, Credit & Banking
THE FEDERAL NATIONAL MORTGAGE ASSOCIATION (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) dominate the U.S. secondary market for conforming single-family residential mortgages as both investors in and securitizers of these loans. (1) As of year-end 2003, these government-sponsored enterprises (GSEs) together held about $1.8 trillion in mostly mortgage-related assets and had another $2.1 trillion in net off-balance mortgage guarantees outstanding. (2) Indeed, these two portfolios accounted for almost 50% of the credit risk and over 20% of the market risk associated with all U.S. residential mortgages outstanding at that time (Frame and White 2005). Further, both Fannie Mae and Freddie Mac are highly leveraged, with ratios of total book equity capital to total assets consistently below 4%. Taken together, the large absolute sizes, portfolio concentrations, and comparatively thin capital ratios of Fannie Mae and Freddie Mac have led the Federal Reserve to conclude that the companies pose a systemic risk to the U.S. economy (Greenspan 2005). (3)
In the wake of recent revelations of significant interest-rate risk exposure (at Fannie Mae) and accounting misstatements (at both Fannie Mae and Freddie Mac), Congress is considering material changes to the companies' federal safety-and-soundness oversight. Among the new legal authorities being considered is the ability of the safety-and-soundness regulator to set minimum capital requirements; the current standards are embedded in statute and can be modified only by an Act of Congress. Such capital requirements are central to any safety-and-soundness structure and should be set commensurate with the risks being undertaken by the regulated firms. In addition to minimum capital requirements (and any direct limits on risk-taking), a positive differential between the market value of a regulated firm's equity and its book value can also serve as a disincentive to risk-taking. This differential is related to the expected future profitability of the firm, which reflects expectations about future competition. During the 1990s and the early part of the current decade, Fannie Mae and Freddie Mac did enjoy a substantial positive differential between the market values and book values of their common equity. Arguably, this partly reflected their special GSE charters, which limited their competition in the secondary conforming mortgage market.
Fannie Mae's and Freddie Mac's charter values may be threatened by potential revisions in the federal government's treatment of the GSEs' two most likely sets of competitors. First, the Federal Home Loan Banks have begun to purchase mortgage loans from their depository institution members. Second, a few of the very largest commercial banks and thrifts may soon enjoy a sharp reduction in the amount of regulatory capital that they must hold against mortgage-related assets. While both mechanisms for increased competition could ultimately increase the transmission of GSE benefits to mortgage borrowers, they could also bring a potential downside: an increase in the risk-taking incentives of Fannie Mae and Freddie Mac due to a loss of charter value. Hence, supervisory authorities should closely monitor these developments and, if necessary, take appropriate action.
Below we examine charter value, risk-taking incentives, and emerging competition at Fannie Mae and Freddie Mac. Before doing so, however, we outline the overall landscape in the secondary conforming mortgage market and briefly describe the special features of these two housing GSEs.
1. THE LANDSCAPE
Homebuyers obtain financing through mortgage lenders, typically depository institutions or mortgage banks, (4) in the primary mortgage market. Primary mortgage lenders, in turn, decide whether and how to hold these financial assets. A lender may hold the mortgages as "whole loans" on its balance sheet, swap mortgages for mortgage-backed securities (which can be held as assets on its balance sheet, or can be sold in the secondary market), or sell the mortgage assets outright. …