Fannie Mae’s awfully big advantages
Compared with ordinary mortal financial corporations, as government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac have numerous built-in competitive advantages conveyed on them by the Federal government, including:
- Implicit credit subsidy: $6.5 billion annually.
- Higher leverage (gearing): Unquantified.
- Exemption from state and local taxes: $0.7 billion annually.
- Exemption from SEC registration: $0.3 billion annually.
- Treasury line of credit: $2.25 billion (to each of Fannie and Freddie).
- Implicit deniable arm of the Federal government: priceless.
It’s worth looking at each in turn.
1. Implicit credit subsidy: $6.5 billion annually Fannie Mae and Freddie Mac are supported by government subsidies that the Congressional Budget Office pegged at $6.5 billion annually in 1995. These are provided in kind, rather than in cash, because they reflect Fannie and Freddie’s ability to access capital more cheaply than the market:
Private financial intermediaries, however, cannot match the low funding costs of the GSEs. To approach the GSEs’ borrowing rates, they would have to raise more private equity capital and other private credit enhancements than do the housing GSEs. In short, they would need to convince lenders that they could replicate the federal guarantee through private means. However, private providers of risk-bearing or credit-enhancement services require compensation commensurate with the assumed risk. The requisite backing from private sources, therefore, is costly. By contrast, the government provides the benefits of low-cost funding without charge.
The GSEs achieve this because they are perceived as being governmentally protected from failing:
Even though the company’s debt offerings clearly state otherwise, the financial markets believe that Fannie Mae’s status as a government-sponsored enterprise implies that the government will provide full faith and credit for Fannie’s debt. It is for this reason that Fannie Mae maintains a AAA credit rating.
This implicit guarantee lives in the never-never-land of doublethink (or, to use a more proper term, cognitive dissonance). The government itself has never said it would guarantee or otherwise underwrite Fannie and Freddie’s portfolios (Barney Frank once excoriated the HUD Secretary for saying so, thus making manifest what everyone agrees should be an acknowledged article of faith), but everybody — and I mean everybody — has acquiesced in a situation where everybody believes that the government would and thus doesn’t press the government to say anything. 2. Higher leverage (gearing) of equity via very low capital ratios By their enabling statutes (Fannie’s called the Federal National Mortgage Association Charter Act), Fannie and Freddie are not required to maintain the same capital ratios as normal financial institutions, a feature they have used to create 98%+ leverage of their equity capital:
At a 78:1 debt-to-equity ratio [Fannie Mae] is levered many times what is allowed international banks. (Debt is defined as mortgages on its books plus the value of its guarantees.)
A 1.2% capital ratio (1 divided by 79) is less than half what even the best (Tier 1) banks are required to maintain. 3. Exemption from state and local taxes: $690 million Under their enabling charter, Fannie and Freddie pay neither state nor local taxes:
In 1999, that exemption saved Fannie and Freddie $690 million.
4. Exemption from SEC filings: $280 million Though the GSEs voluntarily file annual and quarterly reports (SEC Forms 10-K and 10-Q, respectively), they are not required to, and are not subjected to the full compliance obligations and costs other companies face:
According to Treasury Undersecretary Gary Gensler, this exemption was worth $280 million to Fannie and Freddie last year.
This also raises the question as to whether all that SEC compliance would also provide a measure of accountability or investor transparency that would reduce the moral hazard of the perceived (but unstated!) Federal exposure. 5. Treasury line of credit: $2.25 billion each This one is closer to (but not quite) a direct expenditure, since the ability to borrow at the Treasury’s cost essentially means a tap on the Federal purse. It’s indirect in the sense that Treasury is simply throwing its cloak over the first $2.25 billion of borrowings, and that sure is a nice liquidity swing should the 1.2% capital ratio suddenly be consumed (by, say, $9 billion in earnings restatement). 6. Implicit arm of the Federal government: priceless Not only do the GSEs have the preceding list of handy advantages relative to private sector competition, they also benefit from, shall we say, friends in high places, with 5 of the 18 Fannie Mae directors appointed by the President of the United States (and not subject to shareholder vote). What hath Fannie and Freddie wrought? From a business perspective, the real beauty of these Federal benefits is that they are evergreen and expandable — the more you use them, the more they’re worth. State and local taxes, interest rate spread relative to the capital markets, higher gearing — they all scale up on volume. So as the GSEs grow, the amount of their implicit subsidy grows with them. And grow they have:
Assisted by the implied federal guarantee, the housing GSEs have grown into some of the largest financial institutions in the world. Their outstanding securities now exceed $4 trillion–or more than the entire U.S. public debt. In the process, Fannie Mae and Freddie Mac have come to dominate the U.S. residential mortgage market, accounting for almost 57 percent of residential mortgage debt.
What do taxpayers get for their money? Quite a lot… but that’s a discussion for another post.
