Freddie Mac and Fannie Mae may have recently
come to appreciate the old saw "be careful what you wish for."
A year or so ago Federal Reserve Chairman Alan Greenspan was giving the two
government sponsored enterprises (GSEs) a lot of grief about
their loan portfolios, particularly in light of the trouble that both had gotten
into with accounting
irregularities and the regulatory requirements to increase their capital
reserves. It is likely that the executives of both corporations were counting
the days until Greenspan's scheduled retirement.
So, retire he did, only to be replaced by Ben Bernanke. On Tuesday Bernanke,
speaking to a convention of the Independent Community Bankers of America called
for reforms to the system that have probably sent Fannie Mae CEO Roger Mudd
and Freddie Mac CEO Richard F. Syron into an extreme case of the vapors.
Bernanke directed his remarks to what he called the GSEs' "second line
." The first line is its role purchasing mortgages from
originators and packaging them into mortgage backed securities (MBS), backing
them with guarantees and them selling them to investors, thus increasing the
liquidity of the residential mortgage market which, Bernanke said, has made
mortgage credit more widely available, especially to low and middle-income borrowers.
His criticism was leveled at the purchase of mortgage-backed
securities and other types of assets for the GSEs' own investment portfolios.
This line of business, he said, owes its fundamental source of profitability
to the perception that the federal government would not allow a GSE to fail.
This erroneous perception of government guarantees allows the GSEs to borrow
at interest rates below that paid by other private participants in mortgage
markets. "By borrowing at this preferential rate and purchasing assets (including
MBS) that pay returns considerably greater than the Treasury rate, the GSEs
can enjoy profits of an effectively unlimited scale". This, Bernanke said, provides
the GSEs the incentive both to expand the range of assets that they acquire
and to increase the size of their portfolios to the greatest extent possible.
Bernanke discounted the GSE argument that their purchases provide additional
support to the mortgage market (although he also said that for the purpose of
his remarks he would stipulate that the portfolios may serve to enhance liquidity
and reduce costs in some circumstances) and said that these large portfolios
are subject to significant volatility and financial risk. The Federal Reserve
Board and others, he said, have expressed concern that these portfolios may
provide systemic risk to the performance of the broader economy.
He explained that there are two conditions that are common to most episodes
of financial crisis: they usually involve financial institutions
or markets that are either very large or play a critical role in the financial
system and, second the origins (other than in crises caused by non-financial
events such as war) can be traced to failures of due diligence or "market discipline"
by an important group of market participants. Bernanke said that both of these
conditions apply to the Fannie and Freddie situation today. They are certainly
large, holding 20 percent of outstanding residential mortgages worth $1.56 trillion
in 2003. In 2005 the two GSEs together had $5.2 trillion in debt and MBS obligations
outstanding. By comparison, the U.S. government has $4.9 trillion in publicly
held debt. The GSEs also engage in extensive hedging activities and consequently
are among the most active users of derivative instruments.
"In most situations," the Fed chairman said, "policymakers
can rely on market forces to constrain the risk-taking behavior of privately
owned financial organizations." This discipline is effective because creditors
have powerful incentives to monitor the risk-taking and risk-management activities
of their debtors and, if increased risk is suspected they will reduce their
exposure to the organization or demand greater compensation for bearing additional
risk. Thus market responses act as a brake on an organization's risk-taking
behavior and reduce the likelihood of failure.
But, he explained, unlike other private firms, the GSEs face little
or no market discipline from their senior debt holders because of the
belief among market participants that the U.S. government will not allow the
GSEs to fail. Therefore, increased risk-taking does not significantly increase
the GSEs' cost of funding or reduce their access to credit. Indeed GSE debt
trades at a narrow spread over U.S. Treasury debt and below those of other highly
rated financial institutions, including the largest U.S. bank holding companies
and that spread has been remarkably unresponsive to the recent problems of the
All of these factors --the large presence of the GSEs in financial markets,
the lack of market discipline exercised by GSE investors, and the incentives
for continued portfolio growth-- led to a conclusion by the Federal Reserve
that while the GSEs do not seem to pose an immediate risk of financial difficulty,
their portfolios continue to represent a potentially significant source of systemic
Bernanke also cited the low capital-to-assets ratio of the GSE holdings. The
largest bank holding companies generally hold capital equal to 6 percent of
assets and large regional banks generally have capital ratios of about 8 percent.
In comparison, the GSEs hold capital equal to roughly 3.5 percent of assets.
Chairman Bernanke laid out several suggestions for reducing the inherent
risk of the GSEs and promoting the public purposes they serve:
- The GSE regulator should have the authority necessary to set and adjust GSE
capital requirements in line with the risks posed by the GSEs.
- The GSEs should be subject to a clear and credible receivership process,
a process that would establish that both shareholders and debt holders of a
failed GSE would suffer financial losses thus providing an incentive for market
- The GSEs' portfolios should be anchored firmly to a well-understood
public purpose approved by the Congress.
The third point, that GSE portfolios should be anchored to a clear and well-defined
public purpose would help to ensure that society in general--not just GSE shareholders--receives
a meaningful return in exchange for accepting the risks inherent in the portfolios
and would reduce the potential for their unbridled growth while avoiding the
imposition of arbitrary limits or caps.
Bernanke said an obvious and worthy candidate for a public purpose is the promotion
of affordable housing. While Congress has established goals for the GSEs to
meet in this area it is difficult to find evidence that they have had beneficial
effects beyond those arising from their securitization activities for the overall
mortgage market. Indeed, the GSE regulator estimates that less than 30 percent
of current portfolio holdings are "oriented toward affordable housing."
To require the GSEs to focus their portfolios almost exclusively on mortgages
or mortgage-backed securities that support affordable housing would
clearly tie them to a public purpose. The market for affordable-housing products--particularly
mortgages extended to households with below-median-income--is less deep and
liquid than the broader market for residential mortgages and GSE portfolio purchases
might add significant liquidity to the secondary markets for such assets, thereby
reducing costs and increasing credit availability to prospective home purchasers.
In addition, increasing the presence of the GSEs in the market for affordable
housing could help banks fulfill their Community Reinvestment Act obligations
with greater opportunities for securitizing such loans. Such an approach would
set some functional limits on the size of the portfolios and on the range of
assets that GSEs would be allowed to purchase, while preserving the ability
of these companies to operate profitably.
Bernanke stressed that he was not advocating that the GSEs expose themselves
to subprime loans. "Orienting the GSEs' portfolios more toward
affordable housing is an approach which can succeed under the current GSE credit
standards. Indeed, the credit risks associated with an affordable-housing portfolio
need not be any greater than mortgage portfolios generally, so long as the GSEs
continue to adhere to sound underwriting practices."