Fannie Mae: What Will Greenspan Say?
A New York Times op-ed by Peter J. Wallison poses a key question regarding troubled Fannie Mae:
Yet, as much as tougher regulation of Fannie Mae and Freddie Mac is warranted, Congress has so far circled the central issue instead of engaging it. The purpose of tighter regulation is to reduce or control the companies’ risks. But we already know why these risks arise: Fannie Mae and Freddie Mac have accumulated portfolios of mortgages amounting to $1.7 trillion that are financed largely by short-term borrowing.
As Mr. Wallison puts it:
Much of their income depends on the spread between the interest rates on the long-term mortgages they purchase from commercial lenders and the short-term rates on the money they borrow - a strategy that makes them extremely vulnerable to changes in interest rates.
Why is this a risk? As highlighted in a great cogent article by William Poole of the St. Louis Federal Reserve:
As far as I know, there are no closed-end investment companies that hold a portfolio of corporate bonds, financed by their own issues of short and long term debt. The reason, I conjecture, is that there is no implied federal guarantee on such obligations, which means that an investment company could not earn a satisfactory spread from holding a portfolio of marketable corporate bonds financed by its own obligations.
The GSEs, however, have the benefit of the implied federal guarantee, which makes their financial engineering profitable. … The financial engineering has nothing to do with the mortgage market per se and everything to do with the implied federal guarantees.
In other words, the GSEs make a profitable business out of taking risks that the private market will not, by relying on the ‘implied federal guarantee’ that is uniquely available to them.
Might they be motivated to expand this risk? You bet they might.
… When the companies borrow to buy and hold mortgages, it does nothing to reduce mortgage rates.
… a conclusion reinforced by Mr. Poole from the St. Louis Fed:
Under the most conservative financial strategy, Fannie and Freddie could mitigate completely their prepayment risk by issuing long-term callable bonds to finance their holdings of long-term mortgage assets. With such a strategy, the cash inflow from the assets matches exactly the cash outflow required to service the liabilities, and the interest rate and prepayment risk are perfectly hedged.
Fannie and Freddie could be forced to do this by an easy-to-promulgate regulatory change:
In recent Congressional testimony, the Federal Reserve chairman, Alan Greenspan, made a notably sensible suggestion: limit the size of Fannie Mae and Freddie Mac’s portfolios of mortgages and mortgage-backed securities to $100 billion to $200 billion.
He is likely to repeat this idea, and perhaps go beyond it, in Senate testimony scheduled for Wednesday.
What’s the downside?
Limiting their ability to buy and hold mortgages and mortgage-backed securities will substantially reduce their profits.
Is that a problem?
Congress ought to understand that this strategy is a classic case of making society take the risks while private investors take the profits - just as the savings and loan associations that went belly up in the late 1980’s did. If Fannie Mae and Freddie Mac profit from the interest rate risks they are taking, the management and the shareholders pocket the gains; but if they fail or suffer financial reverses because of this risk, the taxpayers will bear the burden.
What will Greenspan say?
He is famous for his obscurity:
“If I seem clear to you, you must have misunderstood.” — Alan Greenspan
