Routing

The Federal National Mortgage Association(Fannie Mae) and the Federal Home LoanMortgage Corporation (Freddie Mac) are the twodominant entities in the secondary residentialmortgage markets of the United States. They arean important and prominent part of a largermosaic of extensive efforts by governments at alllevels to encourage the production and con-sumption of housing.

Fannie Mae and Freddie Mac are a unique partof this effort. Though they appear to be “normal”corporations, each with shares that trade on theNew York Stock Exchange, they in fact have feder-al government origins and entanglements thatmake them quite special. Their specialness is adouble-edged sword, however. On one side, theycause interest rates on many residential mortgagesto be lower than would otherwise be the case; onthe other, their size and mode of operation havecreated a significant contingent liability for thefederal government and, ultimately, for taxpayers.In addition, their size and prominence has recent-ly led to concerns about the larger consequencesfor the U.S. economy if either were to experiencefinancial difficulties.

There is strong evidence that home ownershiphas positive spillover effects for society. However,

the broad policies that encourage home owner-ship simply encourage the consumption of morehousing—at the expense of other things—by thosewho would have bought anyway, with the conse-quence that our society’s resources are less effi-ciently allocated than would otherwise be the case.

The special governmental links that apply toFannie Mae and Freddie Mac yield little that issocially beneficial, while creating significantpotential social costs. The best policy would be toprivatize them completely—that is, to sever all gov-ernmental links and convert them to truly “nor-mal” corporations—as well as to pursue othermeasures that would better address the positiveexternality of home ownership and efficientlyreduce the cost of housing. In the event that trueprivatization does not occur, suitable “second-best” policies would include stronger statementsby Treasury officials that the federal governmenthas no intention of supporting the two compa-nies, improved safety-and-soundness regulationof the two companies, limits on the amounts oftheir debt that can be held by regulated deposito-ry institutions, and increased efforts to focusFannie Mae and Freddie Mac on the segment ofthe housing market where their social benefitswould be greatest.

Fannie Mae, Freddie Mac, and Housing FinanceWhy True Privatization Is Good Public Policy

by Lawrence J. White

_____________________________________________________________________________________________________

Lawrence J. White is the Arthur E. Imperatore Professor of Economics at the New York University Stern School ofBusiness. During 1986–1989 he was a member of the Federal Home Loan Bank Board and a board member ofFreddie Mac.

Executive Summary

No. 528 October 7, 2004

Introduction

The Federal National Mortgage Association(Fannie Mae) and the Federal Home LoanMortgage Corporation (Freddie Mac) are thetwo dominant entities in the secondary resi-dential mortgage markets of the United States.They are an important and prominent part ofa larger mosaic of extensive efforts by govern-ments at all levels to encourage the productionand consumption of housing.

Fannie Mae and Freddie Mac are a uniquepart of this effort. Though they appear to be“normal” corporations, each with shares thattrade on the New York Stock Exchange, theyin fact have federal government origins andentanglements that make them quite special.Indeed, they are often described as “govern-ment-sponsored enterprises” (GSEs). Yet,their specialness is a two-edged sword: On oneside, they cause interest rates on many resi-dential mortgages to be lower than wouldotherwise be the case; on the other, their sizeand mode of operation have created a signifi-cant contingent liability for the federal gov-ernment and, ultimately, taxpayers. In addi-tion, the size and prominence of the twoGSEs has recently led to concerns about thelarger consequences for the U.S. economy ifeither were to experience financial difficulties.

There is strong evidence that home own-ership has positive spillover (“externality”)effects for society and thus that targeted poli-cies to encourage home ownership (by thosewho would otherwise rent) can improve asociety’s allocation of economic resources.However, the broad policies that encouragehome ownership do not address thosespillover effects in a focused way (and policiesthat encourage more rental housing, ofcourse, are contrary to the goal of encourag-ing home ownership). Instead, they simplyencourage the consumption of more hous-ing—at the expense of other things—by thosewho would have bought anyway, with theconsequence that our society’s resources areless efficiently allocated. The encouragementthat is provided through Fannie Mae andFreddie Mac is largely of this broad-based

nature and thus suffers from this same dis-tortionary consequence.1

The special governmental links that applyto Fannie Mae and Freddie Mac yield littlethat is socially beneficial, while creatingpotential social costs. Consequently, theappropriate “first-best” policy would be toprivatize them completely—that is, to severall governmental links and convert them totruly “normal” corporations—as well as topursue other measures that would betteraddress the positive externality of home own-ership and efficiently reduce the cost of hous-ing. In the event that this true privatizationdoes not occur, suitable “second-best” poli-cies are discussed as well.

Some Background

What They DoFannie Mae and Freddie Mac each operate

two related lines of business: They issue andguarantee mortgage-backed securities, andthey invest in mortgage assets. Both busi-nesses warrant further explanation.

Mortgage-Backed Securities. A typicaltransaction in today’s mortgage marketsinvolves a swap of a pool (bundle) of residen-tial mortgages that have been originated by acommercial bank, a savings and loan (S&L)association, or a mortgage bank2 for a set ofmortgage-backed securities (MBS) that havebeen issued by Fannie Mae or Freddie Macand that represent a claim on the interest andprincipal payments on the same mortgagepool. The two companies guarantee timelypayment of principal and interest to the MBSholders and, for that guarantee, charge about20 basis points (0.20 percentage points)annually on the outstanding principalamounts. The originators, in turn, have a liq-uid security that they can hold on their bal-ance sheets (with a substantial regulatoryadvantage for commercial banks and S&Lsover holding the underlying mortgagesthemselves) or sell in secondary markets(which mortgage banks immediately do). Ascan be seen in Table 1, as of year-end 2003 the

2

The size andprominence of

the two GSEs hasrecently led to

concerns aboutthe larger conse-

quences for theU.S. economy if

either were toexperience

financial difficulties.

two GSEs together had more than $2 trillionin outstanding MBS.

Mortgage-Related Assets. Instead of swap-ping MBS for mortgages, Fannie Mae andFreddie Mac may buy the mortgages outrightand hold them in their portfolios (or some-times securitize them and sell the MBS to thepublic). The two companies also repurchasetheir MBS through transactions in the sec-ondary market, and most of their mortgage-related assets are now repurchased MBS. Ascan be seen in Table 1, the two companies’mortgage-related assets at year-end 2003totaled almost $1.8 trillion. The two compa-nies fund their mortgage-related asset hold-ings overwhelmingly through the issuance ofdebt.

Some HistoryFannie Mae was created in 1938, under

the authority of the National Housing Act of1934. Until 1968, it was a unit within the fed-eral government. Its function was to expand

the availability of residential mortgagefinance by buying mortgages from origina-tors and holding the mortgages. These pur-chases were funded through debt issuancesthat were direct obligations of the federalgovernment.

As part of the Housing and UrbanDevelopment Act of 1968, Fannie Mae wasspun off from the federal government andbecame a publicly traded corporation, but itretained an array of special government features(discussed below).3 Its function continued to bethat of expanding the availability of residentialmortgage finance through mortgage purchas-es, largely from mortgage banks, that werefunded overwhelmingly by debt. Also, FannieMae was replaced within the federal govern-ment in 1968 by the Government NationalMortgage Association (Ginnie Mae), an entitywithin the Department of Housing and UrbanDevelopment (HUD) that guarantees MBSthat represent claims on pools of mortgagesthat are insured by the Federal Housing

3

The benefitsenjoyed by theGSEs have created a “halo”of implied federalgovernment protection for thetwo enterprises.

Table 1Fannie Mae and Freddie Mac Assets and Mortgage-Backed Securities, and the Residential Mortgage Market (in bil-lions of dollars)

Fannie Mae Freddie Mac

Retained Mortgage-backed Retained Mortgage-backed Total nonfarm,Total mortgage securities Total mortgage securities residential

Year assets portfolioa outstandingb assets portfolioa outstandingb mortgages

1971 $18.6 17.9 0.0 1.0 1.0 0.1 3911975 31.6 30.8 0.0 5.9 4.9 1.6 5771980 57.9 55.6 0.0 5.5 5.0 17.0 1,1051985 99.1 94.1 54.6 16.6 13.5 99.9 1,7301990 133.1 114.1 288.1 40.6 21.5 316.4 2,9071995 316.6 252.9 513.2 137.2 107.7 459.0 3,7452000 675.2 607.7 706.7 459.3 385.5 576.1 5,5432001 799.9 706.8 859.0 641.1 503.8 653.1 6,1102002 887.5 801.1 1,029.5 752.2 589.9 749.3 6,8422003 1,009.6 901.9 1,300.2 803.4 660.4 768.9 7,715

Note: Includes single- and multifamily mortgages.a Includes repurchased mortgage-backed securities.b Excludes mortgage-backed securities that are held in portfolio.

Authority or the Veterans Administration.Freddie Mac was created in 1970 also to

expand the availability of residential mort-gage finance, primarily through the securiti-zation of mortgages purchased from S&Ls.Though the first MBS were issued by GinnieMae in 1970, Freddie Mac was a fast secondwith its initial MBS issuance in 1971.Through the 1970s and 1980s, Freddie Macwas owned solely by the twelve banks of theFederal Home Loan Bank system and by theS&Ls that were members of the FHLB sys-tem. Freddie Mac became a publicly tradedcompany in 1989, but with the same ties tothe federal government that Fannie Maehas.4

Through the 1970s and 1980s the busi-ness strategies of the two GSEs were some-what divergent, as can be seen in Table 1.Fannie Mae tended to focus on mortgagepurchases for its own portfolio (it issued itsfirst MBS only in 1981), while Freddie Mactended to focus on MBS issuances. Since1990, however, the two companies’ businessstrategies have been largely similar: rapidgrowth of both their portfolio businesses andtheir MBS businesses. Indeed, their growthrates since 1990—especially for Freddie Mac—have been breathtaking. As Table 1 also indi-cates, their growth rates have been far fasterthan that of the overall mortgage markets. Asof 1980, the two companies’ mortgage hold-ings plus MBS accounted for only 7 percentof the total of all residential mortgages. By2003 their aggregate involvement in themortgage market came to 47 percent.

More detailed data on the two companies’shares of various slices of the mortgage mar-kets are available for 2000:5

• 39 percent of the $5.6 trillion total6 of allresidential mortgages;

• 40 percent of the $5.2 trillion total of allsingle-family (one to four units) mort-gages (excluding multifamily);

• 48 percent of the $4.4 trillion total of allsingle-family conventional mortgages(which excludes FHA- and VA-insuredmortgages);

• 60 percent of the $3.5 trillion total of allsingle-family conforming mortgages(which also excludes jumbo mortgages);

• 71 percent of the $2.8 trillion total of allfixed-rate single-family conforming mort-gages (which also excludes adjustable-ratemortgages).

Current SizesAs is indicated in Table 1, as of year-end

2003, Fannie Mae had $1,010 billion in assetsand Freddie Mac had $803 billion in assets,making them the second- and third-largestcompanies in the United States when rankedby assets. In addition, Fannie Mae had $1,300billion in outstanding MBS (i.e., net of theMBS that it had repurchased and was holdingin its asset portfolio), and Freddie Mac had$769 billion in outstanding MBS. They arethe largest and second-largest issuers (andguarantors) of MBS in the United States.

The Special Status of FannieMae and Freddie Mac, and

the ConsequencesFannie Mae and Freddie Mac are not ordi-

nary corporations. They differ from all othercorporations in the United States in manyways. These differences are best illustrated bylisting them under the categories of advan-tages and disadvantages.

Advantages• They were created by Congress and thus

hold special federal charters (unlike virtu-ally all other corporations, which holdcharters granted by a state, often Dela-ware);

• The president can appoint 5 of the 18board members of each company;7

• Each company has a potential line ofcredit with the U.S. Treasury for up to$2.25 billion;

• Both companies are exempt from stateand local income taxes;

• They can use the Federal Reserve as theirfiscal agent;8

4

The presence ofFannie Mae andFreddie Mac in

the secondarymortgage market

influences ratesin the primary

mortgage market.

• Their debt is eligible for use as collateralfor public deposits, for purchase by theFederal Reserve in open-market opera-tions, and for unlimited investment bycommercial banks and S&Ls;

• Their securities are exempt from theSecurities and Exchange Commission’sregistration and reporting requirementsand fees;9

• Their securities are explicitly govern-ment securities under the SecuritiesExchange Act of 1934; and

• Their securities are exempt from the pro-visions of many state investor protectionlaws.

These benefits directly lower GSEs’ costsand have also created a “halo” of implied fed-eral government protection for the two enter-prises. That halo effect has been reinforced bypast government forbearance when FannieMae was insolvent on a market-value basis inthe late 1970s and early 1980s and by a tax-payer bailout of the Farm Credit System(which had similar benefits) in the late1980s.10 Perhaps most importantly, becausethe financial markets believe that the specialGSE status of Fannie Mae and Freddie Macimplies that the federal government wouldcome to their (and their creditors’) rescue inthe event of financial difficulties—despite spe-cific language on every security that they issuethat declares that the securities are not guar-anteed by or otherwise an obligation of thefederal government—their debt is treatedfavorably by the financial markets:11 They canborrow on more favorable terms (i.e., at lowerinterest rates) than their credit ratings asstand-alone enterprises would otherwise justi-fy. Typically, they can borrow at rates that aremore favorable than those of an AAA-ratedcorporation (though not quite as favorably asthe rates on the debt of the U.S. governmentitself), even though their stand-alone ratingswould be about AA– or less; this translates intoabout a 35–40 basis point advantage.12

Similarly, they enjoy about a 30 basis pointadvantage in issuing their MBS as a conse-quence of their special GSE status.13

Disadvantages• Their special charters restrict them to

residential mortgage finance.• They are specifically forbidden to engage

in mortgage origination.• They are subject to a maximum size ofmortgage (linked to an annual index ofhousing prices) that they can finance;14

for 2004 that limit for a single-familyhome is $333,700.15

• The mortgages that they finance musthave at least a 20 percent down payment(i.e., a maximum loan-to-value ratio of80 percent) or a credit enhancement(such as mortgage insurance).

• They are subject to safety-and-soundnessregulation—for example, minimum capi-tal requirements and annual examina-tions—by the Office of Federal HousingEnterprise Oversight.16

• They are subject to “mission oversight” byHUD, which approves specific housingfinance programs and sets social housingtargets for the two companies.

The Effects on Residential MortgagesThe presence of Fannie Mae and Freddie

Mac in the secondary mortgage market influ-ences rates in the primary mortgage market.Their activities cause the rates on the “con-forming” mortgages that they can buy to beabout 20–25 basis points lower than the rateson “jumbo” mortgages.17 In addition, theirpresence may well bring greater stability tothe mortgage markets,18 and historically theywere able to bring greater uniformity andunification to what otherwise would havebeen localized and disconnected markets,since regulatory restrictions on interstatebanking and even intrastate bank branchingin some states persisted for most of the 20thcentury and prevented banks and S&Ls frombringing this unification. Also, the two com-panies may have been focal points for mar-ketwide standard setting with respect to thetechnological advances in the processes ofmortgage origination.19 And, historically,they were important in the development ofMBS and of mortgage securitization general-

5

U.S. public policyencourages theconstruction andconsumption ofhousing.

ly as an alternative efficient mechanism forresidential mortgage finance.

The Policy Issues

Fannie Mae and Freddie Mac do not, ofcourse, exist in a vacuum. There are at leastsix larger issues that surround them anddeserve greater exploration, so as to evaluatethe special position and role of the two com-panies. Those larger issues are: (1) the wide-spread public policies in the United Statesthat encourage the construction and con-sumption of housing; (2) the safety-and-soundness regulation of financial institu-tions where there are concerns about thesocial consequences of the insolvency ofthose institutions; (3) the possible systemicconsequences of their size and behavior; (4)the question of who should bear the interest-rate risks concomitant with the long-termdebt instrument that is the modern mort-gage in the United States; (5) the question ofthe efficient transmission to homebuyers ofthe benefits bestowed on Fannie Mae andFreddie Mac as a consequence of their specialGSE status; and (6) the question of possibleinherent efficiencies or inefficiencies of thetwo companies’ activities. We will addresseach in turn.

HousingU.S. public policy, at all levels of govern-

ment, embraces extensive policies to encour-age the construction and consumption ofhousing. These policies (some are largely his-torical; many still apply) include

• Tax advantages: the exclusion of theimplicit income from housing by owner-occupiers for income tax purposes,while allowing the deduction of mort-gage interest and local real estate taxes;the exemption of owner-occupied hous-ing from capital gains taxation; acceler-ated depreciation on rental housing;special tax credits, exemptions, anddeductions;

• Rent subsidization programs;• Direct government provision of rental

housing (“public housing”);• Mortgage insurance provided by FHA

and VA;• Securitization of FHA and VA mort-

gages by Ginnie Mae;• Securitization of conforming mortgages

by Fannie Mae and Freddie Mac;• Purchases of mortgages for portfolio

holdings by Fannie Mae and FreddieMac;

• Separate depository charters for savingsinstitutions (thrifts) with mandates toinvest in residential mortgages;

• Favorable funding for thrifts and otherdepository institutions that focus onmortgage lending through the FederalHome Loan Bank system; and

• Federal deposit insurance for thrifts andfor other depositories whose portfolioscontain some residential mortgages.

It may be only a modest exaggeration todescribe government policy toward housingas one where “too much is never enough.”

The motives underlying public policyactions are frequently varied and diverse, andthe housing policies just enumerated are noexception. In-kind redistributions of incometoward lower-income households are onecomponent (though that motive cannot jus-tify the various income tax exclusions,exemptions, and deductions, which primari-ly benefit higher-income households). Thebeneficial effects on revenues and employ-ment in the residential construction industryand its complementary industry allies areanother. The encouragement of home own-ership is a third (at least for those policiesthat are not focused on encouraging the pro-vision of rental housing).

There is a reasonable theoretical basis forthe existence of positive externalities thatwould support government policies toencourage home ownership. A standard set ofcontracting and asymmetric informationproblems exist between landlord and tenant,which are internalized when the tenant

6

Though HUDdoes set goals for

Fannie Mae andFreddie Mac

with respect to“affordable hous-

ing,” the bulk oftheir mortgage

purchases do notinvolve the

relevant group.

becomes an owner-occupier. Though many ofthe gains from the solving of those problemsaccrue to the parties themselves, there maywell be positive externalities for the neighbors:To the extent that an owner-occupier takesbetter care of her residence (especially the exte-rior) than does the landlord-tenant combina-tion, the neighbors surely benefit as well.Further, to the extent that the owner-occupiercares more about the neighborhood (becauseof the positive externalities for the owner andhis or her property values) and has a longer-run perspective than does the tenant (or thelandlord, who may not live in the neighbor-hood and is unlikely to be as involved), againthere will be positive externalities from homeownership. Finally, even if the household itselfis a major beneficiary from the conversion tohome ownership, the community may stillbenefit from the household’s improved status(e.g., the household may become more sociallyminded because of its improved status), againimplying externalities.20

There is now a modest but growing empir-ical literature that provides some documenta-tion for the existence of these positive exter-nalities for neighborhoods and positive effectson owner-occupier families themselves.21

The logical linkage to policy from thisexternality would be to have tightly focusedprograms that would encourage low- andmoderate-income households, who may beon the margin between renting and owning,to become first-time homebuyers. Such pro-grams could provide explicit subsidies forreducing down payments22 and reducingmonthly payments.23

Tightly focused programs are not the normin housing, however. Far more common arebroad-based programs that encourage morehousing construction and consumptionthroughout the income and social spectrum.For example, the income tax benefits fromhome ownership are broad-based and, becausethey largely operate as exemptions and deduc-tions rather than as refundable tax credits,tend to favor higher-income households inhigher marginal tax brackets.24

The Fannie Mae and Freddie Mac struc-

ture is of this broad-based nature. Thoughthe two companies’ mortgage purchases andswaps are subject to the ceiling of the con-forming loan limit, that limit is substantiallyabove the 80 percent mortgage on the medi-an-priced home in the United States. Forexample, in 2002, the conforming loan limitfor Fannie Mae and Freddie Mac was$300,700. In that same year, the median priceof a new home that was sold was $187,600;an 80 percent mortgage on that sale pricewould have been $150,080. Also in that yearthe median price on the sale of an existinghome was $158,100, and an 80 percent mort-gage on that sale price would have been$126,400.

Thus, the conforming loan limits allowFannie Mae and Freddie Mac to purchase res-idential mortgage loans that are far beyondthe range that would encompass the low- ormoderate-income first-time buying house-hold.25 Though HUD does set goals forFannie Mae and Freddie Mac with respect to“affordable housing,”26 which the two com-panies have met, the bulk of their mortgagepurchases do not involve the group thatought to be the target of ownership-encour-aging activities.27 Consistent with this, itappears that their activities have not appre-ciably affected the rate of home ownership inthe United States.28

Such broad-based programs mean thatmost beneficiaries would have bought anyway,and the marginal effects are largely to causethem to buy larger and better-appointedhomes, on larger lots, and/or to buy secondhomes (that are larger and better appointed).But the positive externalities likely arise pri-marily from the ownership phenomenon itselfand only modestly (if at all) from the size ofthe home (or from second homes).

In turn, this broad-based encouragementmeans that the United States has invested inan excessively and inefficiently large housingstock and that its stock of other physical (andperhaps human) capital is too small. EdwinMills has estimated that the U.S. housingstock is 30 percent larger than would be thecase if these encouragements were absent and

7

The United Stateshas too muchhousing (at theexpense of othergoods and services).

that U.S. income is about 10 percent lowerthan it could otherwise be.29 Patric Hender-shott has estimated that, as of the mid 1980s,tax considerations alone encouraged a 10 per-cent larger housing stock.30 Martin Gervaishas found that the taxation of the implicitrents on owner-occupied housing (accompa-nied by a compensating adjustment in taxrates) alone could cause general consumptionlevels to increase by almost 5 percent.31 LoriTaylor has found that the over-investment inhousing persisted over the period 1975–1995:“The unmeasured benefit to housing wouldhave to top $220 billion per year (or $300 permonth for each owner-occupied home) tosupport the current allocation of resources.”32

These results can be summarized bluntly:The United States has too much housing (atthe expense of other goods and services), andFannie Mae and Freddie Mac make it worse(while not doing an especially good job offocusing on the low- and moderate-incomefirst-time buyer where the social argument isstrongest).

Safety and SoundnessTo the extent that the financial markets

are correct in their belief about the implicitguarantee—that the U.S. government wouldcome to the rescue of their creditors if eitherof the two companies experienced financialdifficulties33—a moral hazard problem is cre-ated: The creditors do not monitor the twocompanies’ managements as closely as theywould if the creditors were more fearful oflosses.34 In turn, the managements canengage in activities that involve greater risk,since the companies’ owners will benefitfrom the “upside” outcomes while (becauseof the protections of limited liability) beingbuffered from the full consequences of large“downside” outcomes. The creditors’ guaran-tor—the federal government—is thus exposedto potential loss.35

This problem of moral hazard is a generalproblem for the creditors of a limited liabilitycorporation. Outside of the financial sector,creditors long ago realized the existence of theproblem and created monitoring structures,

as well as restrictions in lending agreementsand covenants in bonds, that give creditors theability to restrain owners’ and managers’ risk-taking, especially when net worth levels dimin-ish. For banks and other depositories, wherethe institution’s primary creditors are consid-ered to be less capable of monitoring and pro-tecting themselves against this moral hazardbehavior and where the consequences of bankinsolvency failures have been considered eco-nomically serious (e.g., the potential problemof contagion) and politically serious (the loss-es experienced by individual depositors), feder-al and state safety-and-soundness regulationhas been the public-sector substitute for theprivate monitoring just described. The federalgovernment’s direct exposure to losses,because of federal deposit insurance (since1933) provides another justification for suchregulation.

With respect to Fannie Mae and FreddieMac, the federal government’s exposure topotential losses from excessive risk taking oreven just from errors and poor judgmentswould logically call for safety-and-soundnessregulation, akin to that applied to banks.36

Only in 1992, however, did Congress come tothat realization, in the Federal HousingEnterprises Financial Safety and SoundnessAct. The act created the Office of FederalHousing Enterprise Oversight, lodged withinHUD, as the safety-and-soundness regulatorfor the two companies and instructed theagency to develop forward-looking risk-based capital requirements for them. Only 10years later did the agency succeed in issuing afinal set of those rules. That delay, plusFannie Mae’s revelation of a large exposure tointerest-rate risk in 2002 and Freddie Mac’srevelation in 2003 of the necessity for a mas-sive restatement of its recent years’ incomeand balance sheet statements, have led tocalls for strengthening the regulatory struc-ture. Among the proposals that have beenactively considered are37

• Moving the agency out of HUD (wherethe culture is more focused on housing)and into Treasury (where the culture is

8

Creditors do notmonitor the two

companies’ managements as

closely as theywould if the

creditors weremore fearful of

losses.

more focused on safety and soundness);• Reorganizing the agency as a freestand-

ing agency outside the executive branch,where it would be more independent ofdirect White House influence;

• Bringing the FHLB system (which is cur-rently regulated by a separate—also fre-quently criticized—entity, the FederalHousing Finance Board) under the aegisof whatever agency is created;

• Strengthening the agency’s ability tolevy fees on Fannie Mae and FreddieMac to fund itself, thus removing theagency from the vagaries of annual con-gressional budgetary appropriations;

• Strengthening the agency’s ability to setand revise the minimum capital require-ments that the two companies mustmeet;

• Giving the agency a role in the setting ofsocial targets for the two companies; and

• Giving the agency the power to appointa receiver that could liquidate or other-wise dispose of either company’s assetsin the event that the company wasunlikely to be able to attain its mini-mum capital requirements.

As of September 2004, no definitive leg-islative action had been taken.

Systemic RiskThe general notion of systemic risk is that

the financial problems of one institutioncould have wider spread effects on otherparts of the economy. For commercial banks,a “contagion” effect is one such scenario,whereby depositor “runs” on one shaky bankmight cause worried depositors of otherbanks to withdraw their cash from thosebanks, which would create a liquidity squeezefor those latter banks; or the liquidation ofassets by the banks in their efforts to meettheir depositors’ claims could depress assetvalues sufficiently so that other banks’ assetvalues and solvency were impaired. Alterna-tively, there might be a “cascade” effect,whereby the chain of banks’ claims on oneanother would mean that the insolvency of

one bank would reduce the asset values ofother banks that had claims on the first bank(and this cascade could lead to and reinforcea contagion problem, and vice-versa).

The discussion38 with respect to the possi-ble systemic risks posed by Fannie Mae andFreddie Mac begins with the observationsthat they are very large (recall that they werethe second- and third-largest companies inthe United States at year-end 2003, whenranked by assets), they are highly leveraged(their net-worth-to-assets ratios are in the3–4 percent range), they are focused on a nar-row asset class, their MBS guarantees andinvestment portfolios together embody cred-it (default) risk on over $3.6 trillion of resi-dential mortgage assets (or about 47 percentof the total market), and their investmentportfolios alone embody potential interest-rate risk on $1.5 trillion in mortgage assets.The discussion next splits into the questionof whether they manage their risks suffi-ciently well (given their relatively thin capitallevels) and then the question of what thelarger consequences of financial difficultiesfor one or both companies might be.

The former set of questions is really just amore detailed analysis of the safety-and-soundness issues discussed above. FannieMae and Freddie Mac face two major cate-gories of risk: credit risk (i.e., the risk thatmortgage borrowers will default on their pay-ment obligations and that the prices of therepossessed housing are below the outstand-ing loan balances, which would impair thevalue of the mortgage assets in the compa-nies’ portfolios and/or require the companiesto make payments on their MBS guarantees);and interest-rate risk (i.e., the risk that inter-est rates change after the investment in amortgage, and the risk that changes in inter-est rates could cause the values of their mort-gage portfolios to fall below the values oftheir outstanding debt obligations).39

There is general agreement that the creditrisk on most single-family residential mort-gages has been quite low. The underwritingcriteria used by lenders—primarily adequatehousehold income and a good credit histo-

9

By holding largeportfolios oflargely long-termfixed-rate mort-gages, the twocompanies poten-tially exposedthemselves to extensive interest-rate risk.

ry—are an important initial screen. Further,the home itself serves as the collateral for themortgage in the event of default; most lendersrequire a 20 percent down payment (i.e., amaximum loan-to-value ratio of 80 percent)or some form of mortgage insurance40 to pro-vide a margin in the event of default; the bor-rower’s monthly repayments diminish theunpaid balance, which leaves a greater marginto protect the lender; and home values havegenerally been rising in most areas of theUnited States for over 60 years (which againleaves a greater margin to protect the lender).The credit-risk losses experienced by FannieMae and Freddie Mac averaged 5.4 basispoints annually over the 1987–2002 period,and the losses averaged only one basis pointannually for 1999–2002.41 If there were to bea Great Depression–type of collapse in hous-ing values, however, these credit-risk lossescould deteriorate considerably.42

Instead, the focus has been on interest-rate risk—on the risk that interest rates maychange, which would affect the market valuesof Fannie Mae and Freddie Mac’s mortgageassets and MBS. This concern, of course,applies only to the assets held in the portfo-lios of the two companies, since the holdersof their MBS are the bearers of the interest-rate risk on those MBS. By holding largeportfolios of largely long-term fixed-ratemortgages and MBS that can be prepaidwithout penalty, the two companies poten-tially exposed themselves to extensive inter-est-rate risk. In turn, they issue debt that iscallable (so that, as mortgages prepay, thecompanies can call in the debt that has fund-ed those mortgages), and they use derivativeinstruments, such as interest-rate swaps andoptions on swaps, to construct obligationsthat largely match the profile of their assets.

The two companies’ defenders point tothis debt structure and hedging as evidencethat the companies are doing a good job ofmanaging and dispersing their potentialinterest-rate risks.43 The GSEs’ critics, howev-er, argue that the absence of exact matchingleaves open the possibilities of mistakes,which (given the two companies’ relatively

low capital ratios) could snowball into afunding crisis for either or both companies.44

Further, they point to the large quantities ofthe companies’ interest-rate swaps (thenotional amount was about $1.6 trillion atyear-end 2001), with five counterpartiesaccounting for about 59 percent of theirderivatives. However, the transactions valueof an interest-rate swap (the price of theoption) is a small percentage of the notionalvalue of the swap, and counterparties inderivatives trade are required to post collater-al if their net exposure exceeds certain limits,with lower-rated counterparties’ postingcommensurately more collateral. As of year-end 2001, the net uncollateralized exposuresfor Fannie Mae were only $110 million, andfor Freddie Mac they were only $69 million.In the event of a counterparty default, how-ever, the two GSEs would be exposed to the“rollover risk” of finding new counterparties.

Regardless of which side has the betterargument, these are really disputes that relateto safety-and-soundness of the two compa-nies and should influence issues such as ade-quate levels of capital (net worth) for the twocompanies, given their asset and liabilitystructures and activities and assurances as tocounterparty creditworthiness. The discus-sion of the systemic consequences of the twocompanies’ sizes and actions are, however,linked to these disputes, since how stronglyone feels about the systemic consequences (ifany) of a financial problem by one or bothcompanies is surely influenced by how onefeels about the likelihood that such disrup-tive events could occur.

Any discussion of the systemic conse-quences must start with the sheer sizes of thetwo companies: Their portfolio holdings andoutstanding MBS now account for almost halfof the total of all residential mortgages. On theone hand, this size is a potential element forstability: At times of externally generated stress(e.g., the market stress of September 11, 2001;the potential market meltdown related to thedemise of Long Term Capital Management inSeptember 1998; or the stock market free-fallof October 1987), their continued participa-

10

If either Fannie Mae or

Freddie Mac wereto experience

financial difficulties, there

would be potential effects

on mortgage markets.

tion in the secondary mortgage markets hasbeen and can continue to be a source ofstrength and stability for those markets. Ifeither of them were to begin to falter financial-ly, however, then their size would become a sys-temic liability. Larger companies with greatervolumes of activities and larger liabilities (andmore widespread liability holders and counter-parties) will necessarily have a greater effectwhen they falter. If either Fannie Mae orFreddie Mac were to experience financial diffi-culties, there would be potential effects ontheir existing liability holders as well as poten-tial effects directly on mortgage markets. Thesystemic consequences of each path can beaddressed as follows.

With respect to effects on existing liabilityholders, systemic effects (beyond just thedirect losses experienced by the liability hold-ers and counterparties) would depend on theextent of the direct losses and the extent towhich the directly exposed parties are them-selves leveraged (and thus their losses canimpose further losses on others). The extentof a GSE’s losses in the event of financial dif-ficulties is difficult to predict. On the onehand, with respect to credit risks, the under-lying assets are largely residential mortgagesand ultimately the residential homes them-selves. The experience of the past 60 years isreassuring in this respect. Home values havetended to rise, and even when they have fall-en, they have not fallen to small fractions oftheir peaks (as can happen with the assetsthat underlie commercial loans). Further,both companies are nationally diversified.On the other hand, a reprise of the GreatDepression could erase the relevance of this60 years of experience. And, with respect tointerest-rate risk, the credit-risk experience islargely irrelevant, since the issue is how wellthe institution has hedged its interest-rateexposure. Overall, though a GSE insolvencyis surely not an impossibility—that possibili-ty, after all, is an implication of the stand-alone AA– financial ratings of Fannie Maeand Freddie Mac—the extent of the insolven-cy (in terms of the percentage loss imposedon claims holders) is unlikely to be large.45

With respect to a contagion or cascadingeffect of creditor losses, the primary candi-dates would be depository institutions,which (in aggregate) hold about a sixth of thetwo companies’ debt and about 40 percent oftheir MBS and which are allowed by regula-tion to hold unlimited amounts of theirobligations. A recent study46 shows that, as ofthe third quarter of 2003, depositories’ aggre-gate holdings of the two companies’ debtcame to 3.3 percent of all depositories’ assets,or slightly more than a third of their aggre-gate net worth (which was about 9.1 percentof assets), while their aggregate holdings ofthe GSEs’ MBS came to 8.5 percent of theiraggregate assets.47 Though losses of value ofGSE debt and MBS of, say, 5 percent wouldbe far from a welcome event for depositories,it would also be far from a devastating eventfor most of them and would be unlikely tohave widespread systemic consequences.

As for the direct effects on mortgage mar-kets of financial difficulties by one of the com-panies, it is difficult to imagine that therewould be no consequences when an $800 bil-lion or $1 trillion company withdraws from itsprimary activities. But the extent of the conse-quences would depend on whether and towhat extent and how quickly the other GSEcould pick up the slack,48 as well as how elasticwould be the responses of the other majorproviders of residential mortgage finance.49

Since no such event has occurred, it is difficultto provide estimates of magnitudes.

Finally, there is general agreement thatimproved transparency can reduce market par-ticipants’ misunderstandings and reduce thelikelihood and extent of systemic problems. Inresponse to political pressures, Fannie Mae andFreddie Mac announced in 2000 a set of six“voluntary” initiatives that would improvetheir public disclosures: (1) to issue subordi-nated debt; (2) to meet certain liquidity stan-dards; (3) to enhance credit-risk disclosures; (4)to enhance interest-rate disclosures; (5) toobtain annual “stand-alone” credit ratings; and(6) to self-implement and report their regula-tory risk-based capital levels.50 These steps allseem headed in a sensible direction.51

11

The absence ofprepay penaltiesexacerbates theinterest-rate riskthat is borne bythe holder of amortgage orMBS.

The Absence of Prepay Penalties and theBearing of Interest-Rate Risk

The standard residential mortgage in theU.S. is a long-lived, fixed-rate debt instru-ment, which the borrower can prepay at anytime with no penalty.52 Fannie Mae andFreddie Mac are both cause and effect withrespect to these characteristics, since over 90percent of the mortgages that they buy arefixed-rate instruments, and they rarely buymortgages that have prepay penalties. Theabsence of prepay penalties exacerbates theinterest-rate risk that is borne by the holderof a mortgage or MBS.

This last point can be seen as follows: Theholder of a nonprepayable debt instrument isexposed to interest-rate risk because the valueof the instrument declines when interest ratesincrease but its value increases when interestrates decline. The longer the maturity of theinstrument, the greater are the price swings. Ifthe borrower’s prepayment likelihood were aconstant and not affected by interest-ratemovements—say, prepayments were drivensolely by household mobility, and mobilitywas invariant to interest-rate changes—theseproperties would apply to residential mort-gages as well.

But prepayment behavior is affected byinterest-rate changes, and in ways that areadverse to the lender. If mortgage interestrates decrease from the levels prevailing atthe time of the mortgage origination, theborrower is more likely to repay and refi-nance her mortgage at the lower interestrate.53 Also, households that might not oth-erwise have been tempted to move to a newhome may now find that the lower interestrates make the move (and the repayment ofthe original mortgage) worthwhile.54 Thisquickening of the repayment rate deprivesthe lender of the potential capital gain on themortgage that would otherwise occur on adebt instrument that was not callable; equiv-alently, the greater pace of repayment isoccurring just when the lender doesn’t wantrepayment, since the lender can then only re-lend (or reinvest) the funds at the lower pre-vailing interest rates.

When interest rates rise, prepayments willgenerally not occur for refinancing purposes,55

and even the “normal” flow of mobility-drivenprepayments is likely to decrease as somehouseholds that otherwise would have foundmoving to be worthwhile now find it less so.56

In this case, the capital loss that the lenderwould have experienced on a noncallable debtinstrument is compounded by the slackeningof the prepayment rate; in essence, prepay-ments are slackening, just when the lenderwishes that they would accelerate.57

Thus, if the borrower can prepay themortgage without penalty, the pattern of pre-payments will vary inversely with changes ininterest rates and will exacerbate the interest-rate risk faced by lenders. This extra riskborne by the lender is not free to the borrow-er. Instead, the risk of the borrower’s exercis-ing her option to prepay without penalty isincorporated into the overall interest rateand fees that a competitive market willcharge all borrowers (so long as the lendercannot determine beforehand which borrow-er is more likely to prepay). Accordingly, eventhose borrowers who (for whatever reason)are unlikely to prepay their mortgages mustpay extra because of the greater risk imposedon lenders, and there is a cross-subsidy thatruns from those who are less likely to prepayto those who are more likely to prepay.

Why is the prepay option not priced moreexplicitly—for example, through an explicitpenalty for prepaying (which, in turn, wouldallow a lower interest rate and lower initialfees)? Or, at least, why are borrowers notmore often offered 58 the choice between ano-prepayment-penalty mortgage (with ahigher interest rate and initial fees) and a pre-payment penalty mortgage (with a lowerinterest rate and initial fees)? At least part ofthe reason appears to be a patchwork of stateregulations that, in some states, limits (orforbids) the ability of state-chartered deposi-tories to impose prepayment penalties.However, the buying patterns of Fannie Maeand Freddie Mac—they almost exclusivelypurchase no-prepayment-penalty mortgages—also influence the outcome.

12

There is a cross-subsidy that runs

from those whoare less likely toprepay to those

who are morelikely to prepay.

Why, in turn, do the two GSEs buy almostexclusively no-prepayment-penalty mort-gages? This may be, in part, an element ofstandardization, since an array of differentprepayment penalties could add to the infor-mational burden on MBS investors to knowwhat penalties applied to the MBS that theyheld and what the consequences for prepay-ments might be. But this cannot be the entirestory, since it would surely be possible foreither company to announce that it would bewilling to buy mortgages that had one or twoprepayment penalty patterns and therebymaintain a reasonable level of standardiza-tion, as is true for the companies’ purchasesof adjustable-rate mortgages (which, in prin-ciple, can have a wide variety of terms). Sincethe two companies maintain huge portfoliosof these no-prepayment-penalty mortgagesand MBS with their concomitant exacerbatedinterest-rate risk, which must then be man-aged, it may well be the case that they believethat they have a comparative advantage atmanaging this exacerbated interest-rate risk.In any event, it is clear that the states’ inhibi-tions on penalties are complementary to theGSEs’ business strategies.

As a related matter, so long as the lend-ing/borrowing arrangement with respect to ahome involves long-term finance, interest-raterisk unavoidably arises and cannot (from aneconomywide perspective) be diversified away.59

Two questions then arise: (1) Who bears theinterest-rate risk? and (2) Who should bear thatrisk?

The first question is easier to answer:With adjustable-rate mortgages (ARMs), theborrower bears the risk. With long-termfixed-rate mortgages that are nonprepayable,the lender or the MBS holder bears most ofthe risk.60 The interest-rate risk borne bylenders on long-term fixed-rate mortgages isexacerbated by the current practice of allow-ing borrowers to prepay their mortgageswithout penalty. In essence, the penalty-freeprepay option allows the borrower to shed allinterest-rate risk.

The second question is harder. Some gen-eral principles can be stated, however. First,

diversification of that risk is surely a goodthing. Second, the bearing of that risk shouldbe by individuals or institutions that areknowledgeable and skilled at managing therisk and that are in a financial position tobear it without undue financial hardship(and without creating the transactions costsof bankruptcies, etc.). This surely argues forallowing (but not requiring, nor forbidding)mortgage originators to offer ARMs to thoseknowledgeable borrowers who want them. Italso argues for allowing mortgage origina-tors to offer fixed-rate mortgages that may(or may not) include prepayment penalties,which would allow the prepayment risk to beexplicitly priced, and then letting market par-ticipants choose. It is far from clear that thefederal government needs to be the explicit orimplicit backstop for this process through itsmaintenance of the special GSE status ofFannie Mae and Freddie Mac (or of the FHLBsystem).61

Efficient Transmission of BenefitsWithin the sphere of conforming mort-

gages, Fannie Mae and Freddie Mac are a pro-tected duopoly, which could affect their pric-ing behavior and thus the extent to whichthey pass through to homebuyers the bene-fits that they receive as a consequence of theirspecial GSE status. At one extreme, despitetheir duopoly structure, they might behavelike perfectly competitive firms and passthrough 100 percent of the benefits to home-buyers; at the other extreme, they might col-lude and retain all of the benefits for theirshareholders.

Dennis Carlton, David Gross, and RobertStillman conclude that the two companies’activities do not raise antitrust concerns.62

Nevertheless, the issue of whether the twocompanies exercise market power remains aninteresting one.

It does appear that the two companies haveheld on to at least part of their special benefitsand have earned supranormal returns.63 Forexample, for the years 1998–2002, Fannie Maeearned an average return on equity (ROE) of25.4 percent (and was at or above 25.0 percent

13

Skepticism iswarranted as towhether the twocompanies’ special GSE status adds extraefficiency tomortgage markets.

for each of those years), while Freddie Macearned an average of 24.2 percent for thosesame years; by contrast, the industry ROE forall FDIC-insured commercial banks for thesame five years was around 14 percent.64 Arecent estimate of the gross and net benefits ofthe GSEs’ special status is consistent withthese results.65 In 2003 the two GSEs received,as a consequence of their special status, grossbenefits of about $19.6 billion, of which theypassed through about two-thirds ($13.4 bil-lion) to homebuyers through lower mortgagerates and retained about one-third ($6.2 bil-lion) for their shareholders.

There is, however, a deep irony to the con-sequences of this exercise of market power forallocative efficiency: To the extent that onebelieves (as was argued above) that public poli-cies in general encourage too much housingand that the two companies’ activities make itworse, their exercise of market power (imply-ing that mortgage rates are not as low as if theybehaved wholly competitively and thus homebuying is not as encouraged) means that glob-al allocative efficiency is improved.

Possible Inherent Efficiencies orInefficiencies

Does the special GSE status of Fannie Maeand Freddie Mac create a special and inherentefficiency for providing mortgage finance?The answer to this question goes beyond thehistorical role of the two entities in encourag-ing mortgage securitization, since asset securi-tization is now a well-established and widelyemployed technique in finance.

Skepticism is warranted as to whether thetwo companies’ special GSE status adds extraefficiency to mortgage markets. First, as isargued above, the current broad-basedapproach of the two companies is surely notan efficient way to address the positive exter-nality with respect to home ownership.

Second, there is the issue of transactionscosts with respect to the credit risk on resi-dential mortgages.66 To provide assurancesof timely payments to the holders of theirMBS, “private-label” (i.e., private, non-GSE)issuers usually create a senior-subordinated

structure (whereby the subordinated securityabsorbs the first credit losses) that protectsthe holders of the senior MBS. The creationof this structure involves transactions costs,as does the process of obtaining a rating onthe senior MBS from one or more ratingagencies (e.g., Moody’s or Standard &Poor’s). Investors in the senior MBS would beinterested in learning whether some of thesubordinated MBS tranches are experiencinggreater losses than was expected (whichwould mean greater risks for the associatedsenior MBS), thus entailing further monitor-ing (transaction) costs. The blanket credit-loss guarantees issued by Fannie Mae andFreddie Mac (backed by the implicit federalguarantee) eliminates all of those costs.

This argument is surely correct as far as itgoes. But the Fannie-Freddie process guaran-tee must then be backstopped by the govern-ment-oriented safety-and-soundness regula-tory process described above and ultimatelyby taxpayers. Which route offers the lowestcosts (short run or long run) is not obvious.

A third argument is that the new-era securi-tization process is inherently more efficientthan is the depository-driven process of yoreand that the expansion of Fannie Mae andFreddie Mac (with their implicit federal guar-antee) at the expense of depositories’ (withtheir explicit federal deposit insurance) hold-ings of conforming residential mortgages isevidence of this superior efficiency.67 However,regulatory considerations have also played animportant role in the GSEs’ growth. Com-mer-cial banks and S&Ls have been encouraged tohold MBS rather than whole mortgage loansby risk-based capital requirements (which havebeen in place since 1988) that require only 1.6percent capital for holding any MBS that israted AA or better but require 4 percent forholding unsecuritized residential mortgages.Further, the capital requirements that haveapplied to Fannie Mae’s and Freddie Mac’sholdings of mortgages (2.5 percent) have beensubstantially less than the capital requirementsthat have applied to depositories’ holding ofmortgages (4 percent), giving the former a costadvantage. Accordingly, though mortgage

14

An outright privatization

of the two companies would

be the first-bestoutcome.

securitization (as an efficient innovation of the1970s and 1980s) was surely going to grow andgain market share relative to the traditionaldepository route, the extent of the GSEs’growth is not necessarily an indicator of theirspecial and inherent efficiencies.

As for possible inherent inefficiencies thatmay accompany the two companies’ specialGSE status, there is no assurance that the cur-rent managements and organizational struc-tures for Fannie Mae and Freddie Mac are themost efficient for doing what they do. SinceCongress has issued only two charters of thisparticular kind, the ability of competitiveprocesses to reward more efficient firms andwinnow less efficient firms from the market-place is inhibited. Further, the two firms arenot required periodically to bid for their fran-chises in an auction against potential replace-ments; they have been “grandfathered” indefi-nitely. And the market for corporate controlcannot operate effectively: Their limited char-ters make them immune to takeover by anyother firm, and their large size and specialGSE status make them virtually immune to a“hostile” takeover by an investor group.

As a related matter, whenever either of thetwo firms has expanded slightly in “horizon-tal” (e.g., subprime lending) or “vertical” (e.g.,providing underwriting software to mortgageoriginators) direction—or even publicly con-templated such moves—critics have com-plained that the two companies’ ability toexpand arises solely from the low-cost fundingthat they enjoy because of the implicit guaran-tee and not because of any inherent efficiencyadvantage (and that they are in fact elbowingaside inherently more efficient enterprises).Without a “clean” market test, there is no wayto resolve such questions.

What Is to Be Done?

First-Best OptionThe analysis provided above points in a

clear direction with respect to Fannie Maeand Freddie Mac: Since there seems to be nospecial efficiency reason for preserving their

special GSE structure, since they mostly justadd to an already excessive amount ofencouragement for housing in the UnitedStates, since their role in addressing theimportant social externality of home owner-ship is modest at best, and since the impliedguarantee (to the extent that it would be hon-ored) creates a contingent liability for theU.S. government, an outright privatization ofthe two companies—the withdrawal of theirspecial charters and their conversion to nor-mal corporations—would be the first-bestoutcome. This would imply that the twocompanies would no longer enjoy any specialprivileges, but would no longer be restrictedto their current narrow slice of the financialworld.68 How these companies and theirowners would fare in that scenario wouldthen be a matter for markets, and not theCongress or OFHEO, to decide.69

As an historical matter, the presence ofFannie Mae and Freddie Mac and theirimplied guarantees may well have beenimportant for the innovation and develop-ment of mortgage securitization in the 1970sand 1980s. Nevertheless, mortgage securiti-zation is now a well-established technologyof finance that would easily survive the priva-tization of the two companies.

The consequence of true privatization forresidential mortgage markets would be mod-est: Mortgage rates would be about 25 basispoints higher than would otherwise be thecase. Grass would surely not grow in thestreets of America as a consequence—andwould surely continue to grow in most back-yards. And, because the United States alreadybuilds and consumes too much housing, thiswould be a move in the right direction.

In their place, the federal governmentought to deal directly with the true positiveexternality related to housing: encouraginglow- and moderate-income first-time buyers.Such a program should be an explicit on-budget encouragement for such home pur-chases, with subsidies for down payments70

and for monthly payments.As part of this true privatization, the sec-

retary of the Treasury should state clearly at

15

Mortgage securitization isnow a well-established technology offinance thatwould easily survive the privatization ofthe two companies.

the congressional hearings that the Treasury(after the passage of the privatization legisla-tion) would treat the two companies just likeother corporations in the U.S. economy,would not consider the two companies to be“too big to fail,” and would have no intentionof “bailing them out” in the event of subse-quent financial difficulties. The presidentshould reiterate this message at the officialsigning of the legislation. Also, bank andS&L regulators should revise their “loans-to-one-borrower” regulations so that deposito-ries’ holdings of Fannie Mae and FreddieMac debt would be treated similarly to theirholdings of other companies’ debt (i.e., loansto any single borrower normally cannotexceed 10 percent of the depository’s capital),rather than the unlimited holdings that arecurrently permitted.71

Further, in order to ameliorate the con-centration of interest-rate risk that the cur-rent structure of fixed-rate mortgages with-out prepayment penalties places on lendersor MBS holders and that may be an extra ele-ment that unduly strengthens the role ofFannie Mae and Freddie Mac in the mort-gage markets, lenders should have the free-dom to offer mortgages that would include afee for the prepayment option that is usuallynot explicitly priced (but is surely included inthe overall pricing of mortgages). Suchexplicit pricing will also eliminate the cross-subsidy that currently runs from those whodo not exercise the option to those who do.State laws and regulations that inhibit suchexplicit pricing should be repealed.

In addition, there are at least two positivemeasures that could reduce the cost of hous-ing in efficiency-enhancing ways. First, andforemost, the federal government shouldcease placing impediments to internationaltrade in construction materials; removal ofthe current trade impediments to the importof Canadian lumber would be an excellentplace to start.72 Second, inefficient localbuilding codes that raise the costs of housingconstruction more than is warranted by safe-ty or similar considerations should be modi-fied or eliminated. Third, states and metro-

politan areas need to develop procedures totake into account the communitywide conse-quences on housing costs of local “large-lot”zoning measures that restrict the availabilityof land for lower-cost, higher-density hous-ing in areas where land would otherwise beinexpensive.73

Second-Best MeasuresThe true privatization of the two compa-

nies may well be unlikely in the current polit-ical environment. The political attractivenessof an arrangement that reduces housingcosts but has no on-budget consequences ispowerful. Accordingly, second-best measuresshould be considered.

First, regardless of what’s done withrespect to Fannie Mae and Freddie Mac, anexplicit housing program for low- and mod-erate-income first-time buyers is worthundertaking in its own right. So are anyefforts to allow explicit pricing of the prepay-ment option and the efficiency-enhancingefforts to reduce the cost of housing.

Second, even if the two companies retaintheir GSE status, bank and S&L regulatorscould still apply the loans-to-one-borrowerlimitations to depositories’ holdings of theirdebt, as suggested above.74

Third, as a way to reduce the financialmarkets’ belief in the “implicit guarantee,”the secretary of the Treasury should stateloudly and at frequent intervals that it is thepolicy of the federal government to adhere towhat is stated on the Fannie Mae and FreddieMac securities: that these are not obligationsof the federal government and that theTreasury has no intention of “bailing themout” in the event that they become financial-ly troubled. As discussed above, such explicitdenials have not been enunciated in the past.

Fourth, in addition to keeping or evenincreasing the pressures of HUD’s affordablehousing “mission” goals with respect to thetwo companies’ purchases of mortgages,75

the two companies should be forced to con-centrate further on the lower end of thehousing market by freezing the conformingloan limit at its current level of $333,700 and

16

The secretary ofthe Treasuryshould state

loudly and at frequent intervalsthat these are notobligations of the

federal govern-ment and that the

Treasury has nointention of

“bailing themout.”

waiting for median sales prices (or 80 percentof median) to catch up to that level beforeresuming indexed annual increases. Thisfreeze would also have the beneficial effect oflimiting the two companies’ growth andthereby reducing potential systemic risks.

Fifth, the safety-and-soundness regimeshould be strengthened through the transferof OFHEO to the aegis of the Treasury, witha structure and powers (especially receiver-ship powers) that resemble those of the regu-latory agencies for depository institutionsthat are currently housed within theTreasury: the Office of the Comptroller ofthe Currency (for national banks) and theOffice of Thrift Supervision (for S&Ls andsavings institutions). The major argumentagainst such strengthening is, as was dis-cussed above, the risk that such strengthen-ing would also strengthen the financial mar-kets’ belief in the implicit guarantee. Thoughthis possibility is troubling, the dangers ofnot strengthening the regulatory regimeappear to be even greater.76

In sum, housing is too important (butalso too plentiful) to be left to the tendermercies of the current arrangements thatapply to Fannie Mae and Freddie Mac. Thefirst-best path of privatization may not bepossible in the current political climate, butsome constructive second-best measuresdeserve serious consideration.

Notes1. Other broad discussions of Fannie Mae andFreddie Mac can be found in, for example, U.S.Congressional Budget Office, “Federal Subsidiesand the Housing GSEs,” 2001; W. Scott Frame andLarry Wall, “Financing Housing through Govern-ment-Sponsored Enterprises,” Economic Review 87(First Quarter 2002), pp. 29–43; Lawrence J. White,“Focusing on Fannie and Freddie: The Dilemmasof Reforming Housing Finance,” Journal of FinancialServices Research 23 (February 2003): 43–58; U.S.Office of Federal Housing Enterprise Oversight,Systemic Risk: Fannie Mae, Freddie Mac and the Role ofOFHEO (Washington: OFHEO, 2003); William R.Emmons, Mark D. Vaughn, and Timothy J. Yeager,“The Housing Giants in Plain View,” RegionalEconomist (July 2004), pp. 5–9; and W. Scott Frameand Lawrence J. White, “Fussing and Fuming over

Fannie and Freddie: How Much Smoke, HowMuch Fire?” Journal of Economic Perspectives, forth-coming.

2. Mortgage banks are originators of mortgagesthat, unlike commercial banks or savings andloans, do not retain the mortgages or mortgage-backed securities as investments but insteadimmediately sell the mortgages or mortgage-backed securities.

3. Apparently, a major reason for the spin-off atthe time was to remove its debt (which becamethe obligation of the company) from the federalgovernment’s national debt total.

4. A major motive for the conversion of FreddieMac to a publicly traded company was the beliefthat a wider market for its stock would raise theprice of its shares that were held by the then-ailingsavings-and-loan industry and would thusimprove the balance sheets of the latter.

5. See Congressional Budget Office.

6. This figure is slightly different from the onethat appears in Table 1 because the latter has beenupdated.

7. In 2004 the Bush administration announcedthat it would cease appointing any members toeither board, as an effort to begin to reduce thespecial status of the two companies.

8. In addition, through at least mid 2006, they willbe able to receive interest-free “daylight overdrafts”from the Federal Reserve, whereby the Fed makespayments on behalf of the two companies at thebeginning of the business day but does not receivepayment from them until the end of the businessday. In February 2004 the Fed announced that itintends (as of July 2006) to begin charging theminterest on these loans, as it does for all otherfinancial institutions. See Federal Reserve pressrelease, February 5, 2004; http://www.federalreserve.govboarddocs/press/other/2004/20040205/default.htm.

9. In 2002, in an effort to quell criticism and fendoff legislative action, the two companies “volun-tarily” announced their intention to adhere to theSEC’s reporting requirements, although onlyFannie Mae has thus far actually registered itssecurities.

10. See Edward J. Kane and Chester Foster, “ValuingConjectural Government Guarantees of FNMALiabilities,” in Proceedings: Conference on Bank Structureand Competition (Chicago: Federal Reserve Bank ofChicago, 1986); and U.S. General Accounting Office,Government-Sponsored Enterprises: The Government’s

17

Exposure to Risks (Washington: GAO, 1990).

11. As one indicator of that implied protection,the financial pages of major newspapers set asidea separate “box” of “government agency issues” toreport the yields on their bonds (and on those ofthe other GSEs), immediately adjacent to the boxthat shows the yields on Treasury debt.

12. The extent of this advantage varies over timeand with the nature and maturity of the financialinstrument and with general financial conditions.See, for example, Brent W. Ambrose and ArthurWarga, “Implications of Privatization: The Costs toFannie Mae and Freddie Mac,” in U.S. Departmentof Housing and Urban Development, Studies onPrivatizing Fannie Mae and Freddie Mac (Washington:HUD, 1996), pp. 169–204; Brent W. Ambrose andArthur Warga, “Measuring Potential GSE FundingAdvantages,” Journal of Real Estate Finance andEconomics 25 (September–December 2002): 129–150; Frank E. Nothaft, James E. Pearce, and StevanStevanovic, “Debt Spreads between GSEs andOther Corporations,” Journal of Real Estate Financeand Economics 25 (September-December 2002):151–172; and Wayne Passmore, “The GSE ImplicitSubsidy and the Value of Government Ambiguity,”Federal Reserve Board Finance and EconomicsDiscussion Series Number 2003-64 (2003), http://www.federalreserve.gov/pubs/feds/2003/200364/200364pap.pdf.

13. See, for example, U.S. Department of theTreasury, “Government Sponsorship of theFederal National Mortgage Association and theFederal Home Loan Mortgage Corporation,”Washington, 1996; Congressional Budget Office,“Assessing the Public Costs and Benefits ofFannie Mae and Freddie Mac,” 1996; andCongressional Budget Office, “Federal Subsidiesand the Housing GSEs.”

14. These mortgages are usually described as“conforming” or “qualifying” mortgages; largermortgages are usually described as “jumbos.”Other nonconforming mortgages (besides jum-bos) are those that do not meet the prime credit-quality standards of the two companies.

15. This limit applies only to a single-unit resi-dence; higher limits apply to two-unit, three-unit,and four-unit residences and to multifamilyhousing. Limits for Hawaii, Alaska, and the VirginIslands are 50 percent higher.

16. The presence of these safety-and-soundnessrequirements may also be a positive attribute,since it may strengthen the financial markets’belief that Fannie Mae and Freddie Mac are thebeneficiaries of the federal government’s impliedguarantee of the liabilities.

17. See, for example, Congressional Budget Office,“Federal Subsidies and the Housing GSEs”; JosephMcKenzie, “A Reconsideration of the Jumbo/Non-Jumbo Mortgage Rate Differential, Journal of RealEstate Finance and Economics 25 (September-December 2002): 197–213; and Brent W. Ambrose,Michael LaCour-Little, and Anthony B. Sanders,“The Effect of Conforming Loan Status onMortgage Yield Spreads: A Loan Level Analysis,”Journal of Real Estate Economics, forthcoming.

18. See, for example, Gloria Gonzalez-Rivera,“Linkages between Secondary and PrimaryMarkets for Mortgages: The Role of RetainedPortfolio Investments of the Government-Sponsored Enterprises,” Journal of Fixed Income 11(June 2001): 29–36; Andy Naranjo and AldenToevs, “The Effects of Purchases of Mortgagesand Securitization of Government SponsoredEnterprises on Mortgage Yield Spreads andVolatility,” Journal of Real Estate Finance andEconomics 25 (September-December): 173–95; andJoe Peek and James A. Wilcox, “SecondaryMortgage Markets, GSEs, and the ChangingCyclicality of Mortgage Flows,” in Research inFinance 20, ed. Andrew Chen (Amsterdam:Elsevier, 2003), pp. 61–80.

19. There are “network” benefits to standardiza-tion; but there are also risks that a standardbecomes a barrier to entry and to further innova-tion. See, for example, Lawrence J. White, U.S.Public Policy toward Network Industries (Washing-ton: AEI-Brookings Joint Center for RegulatoryStudies, 1999).

20. The community may also feel that it “knowsbetter” than the household with respect to someissues, like encouraging saving. Home ownershiptends to be a way of encouraging a household tosave more (through efforts to collect funds for thedown payment and through the “forced saving”of principal repayments on the mortgage), solong as home values do not decline.

21. See, for example, William M. Rohe and MichaelA. Stegman, “The Impact of Homeownership onthe Social and Political Involvement of LowIncome People,” Urban Affairs Quarterly 30, no. 1(1994): 152–74; William M. Rohe and Leslie S.Stewart, “Homeownership and NeighborhoodStability,” Housing Policy Debate 7, no. 1 (1996):37–81; Peter H. Rossi and Eleanor Weber, “TheSocial Benefits of Homeownership: EmpiricalEvidence from National Surveys,” Housing PolicyDebate 7, no. 1 (1996), pp. 1–35; Richard K. Greenand Michelle J. White, “Measuring the Benefits ofHomeowning: Effects on Children,” Journal ofUrban Economics 41 (May 1997): 441–61; DanielAaronson, “A Note on the Benefits of Homeown-ership,” Journal of Urban Economics 47 (May 2000):

18

356–69; and George Galster, Nancy Gardner, MarvMandell, Dave E. Marcotte, and Hal Wolman, “TheImpact of Family Homeownership on Children’sEducational Attainment and Earnings duringEarly Adult-hood,” presented at the Association forPublic Policy Analysis and Management Meetings,November 8, 2003, mimeo.

22. For evidence that the size of down payment canbe a binding constraint for low-income house-holds, see Peter Linneman and Susan M. Wachter,“The Impact of Borrowing Constraints on HomeOwnership,” Journal of the American Real Estate andUrban Economics Association 17 (December 1989):389–402; and Roberto G. Quercia, George W.McCarthy, and Susan Wachter, “The Impacts ofAffordable Lending Efforts on HomeownershipRates,” Journal of Housing Economics 12 (March2003): 29–59.

23. Even in the context of the social benefits, how-ever, it should be remembered that home owner-ship may not be the best choice for all households,since: (1) a home is a large, risky, illiquid asset withsubstantial transactions costs for buying and sell-ing (including the sale that may arise from foreclo-sure); (2) not all households may have the low vari-ance in income (or other assets) or the discipline inbudgeting that is necessary for the constantmonthly payments that are necessary to pay off amortgage; and (3) the illiquidity and high transac-tions costs of home sales may impede labor mobil-ity and thus reduce flexibility in seeking newemployment. See, for example, William M. Rohe,Shannon Van Zandt, and George McCarthy, “TheSocial Benefits and Costs of Homeownership,”Working Paper no. 00-01, Research Institute forHousing America, Arlington, Virginia, 2000; andGeorge McCarthy, Shannon Van Zandt, andWilliam Rohe, “The Economic Benefits and Costsof Home Ownership: A Critical Assessment of theResearch,” Working Paper no. 01-02, ResearchInstitute for Housing America, Arlington, Virginia,May 2001.

24. See Harvey S. Rosen, “Housing Decisions andthe U.S. Income Tax: An Econometric Analysis,”Journal of Public Economics 11 (February 1979):1–23; and Martin Gervais, “Housing Taxationand Capital Accumulation,” Journal of MonetaryEconomics 49 (October 2002): 1461–89.

25. By contrast, the limits for FHA- and VA-insured mortgages, which are about 50–60 per-cent of the conforming loan limit, are more tight-ly tailored to the appropriate social target.

26. The goals involve (1) a broad target involvinghouseholds with less than median incomes; (2) ageographically focused target involving under-served areas, such as low-income and high-minor-

ity census tracts; and (3) a special target involvinglow-income and very-low-income living in low-income areas.

27. During 1999–2002, of Fannie Mae’s purchases,42.5 percent were home loans for low- and moder-ate-income households; of Freddie Mac’s purchas-es, the percentage was 42.3. Similarly, only 26.5 per-cent of the two companies’ purchases involvedloans to first-time homebuyers. Those percentageswere below those of all lenders for conventional-conforming residential mortgages. See U.S. Officeof Management and Budget, Budget of the UnitedStates Government, Fiscal Year 2004: AnalyticalPerspectives (Washington: Government PrintingOffice, 2004), p. 84. See also Jonathan Brown,“Reform of GSE Housing Goals,” in Serving TwoMasters, yet out of Control: Fannie Mae and Freddie Mac,ed. Peter J. Wallison, (Washington: AEI Press, 2001),pp. 153–65; Lance Freeman, George Galster, andRon Malega, “The Impact of Secondary MortgageMarket and GSE Purchases on UnderservedNeighborhood Housing Markets: A Cleveland CaseStudy,” Report to the U.S. Department of Housingand Urban Affairs, January 2003, mimeo; and U.S.Department of Housing and Urban Development,“HUD’s Regulation of Government-SponsoredEnterprises,” April 7, 2004, and linked charts andgraphs, http://www.hud.gov/offices/hsg/gse/gse.cfm.

28. See, for example, Ronald Feldman, “MortgageRates, Homeownership Rates, and Government-Sponsored Enterprises,” Federal Reserve Bank ofMinneapolis, The Region 16, no. 1 (2002): 4–24;and Gary Painter and Christian L. Redfearn, “TheRole of Interest Rates in Influencing Long-RunHomeownership Rates,” Journal of Real EstateFinance and Economics 25 (September-December2002): 243–67.

29. See Edwin S. Mills, “Has the United StatesOverinvested in Housing?” Journal of the AmericanReal Estate and Urban Economics Association 15(Spring 1987): 601–16; and Edwin S. Mills,“Dividing up the Investment Pie: Have WeOverinvested in Housing?” Federal Reserve Bankof Philadelphia Business Review (March/April1987), pp. 13–23.

30. Patric H. Hendershott, “Tax Changes and CapitalAllocation in the 1980s,” in The Effects of Taxation onCapital Accumulation, ed. Martin Feldstein (Chicago:University of Chicago Press, 1987), pp. 259–90; seealso Harvey S. Rosen, “Housing Subsidies: Effects onHousing Decisions, Efficiency, and Equity,” inHandbook of Public Economics, vol. 1, eds. Alan J.Auerbach and Martin Feldstein (Amsterdam: North-Holland, 1985), pp. 375–420.

31. Gervais.

19

32. Lori L. Taylor, “Does the United States StillOverinvest in Housing?” Federal Reserve Bank ofDallas Economic Review (Second Quarter 1998), p. 16.

33. It is important to note that no presidentialadministration has explicitly rejected the conceptof the implicit guarantee. More typical are care-fully crafted comments along the following lines:“The privileges feed a market perception that GSEdebt is backed by the US government. This is inac-curate—the charters do not require the federalgovernment to bail out a troubled GSE.” N.Gregory Mankiw, “Keeping Fannie and FreddieSafe,” Financial Times, February 24, 2004, p. 15.

34. In an important sense, this moral hazard isthe reverse side of the lower borrowing costs ofFannie Mae and Freddie Mac. Recall that thecredit markets treat them as better than AAA,even though they would otherwise be rated as AA-or below. Without the implied guarantee, thefinancial markets would either insist on astronger balance sheet with more capital (networth) as protection (which would be costly forthe two companies) to achieve the AAA ratingcommensurate with the current interest rates atwhich they borrow, or the financial marketswould insist on charging higher interest rates(which would be costly) commensurate with theircurrent balance sheets and their AA- ratings.

35. The federal government’s contingent liabilitycan be roughly estimated by posing the followingquestion: What would the federal governmenthave to pay annually to a third-party guarantor totake over the federal government’s likely obliga-tions to the two GSEs’ debt and MBS holders?This question can be answered by examining theborrowing advantages of the two GSEs, sincethese advantages reflect the difference betweenthe interest payments that the financial marketswould require in the absence of the federal gov-ernment’s implied guarantee and the two GSEs’actual borrowing costs; as is described above, theadvantages are approximately 35–40 basis pointson debt and 30 basis points on MBS. If thesespreads are multiplied by the outstanding debt ofthe two GSEs, the annualized contingent liabilitycomes to approximately $12–13 billion.

36. About the only argument against such regula-tion, besides any inefficiencies that its actual exe-cution might bring, is that the imposition of thesafety-and-soundness regime itself might strength-en the market’s belief in the implied guarantee andalso strengthen the government’s belief that itmust (in the event that, despite the regulatoryregime’s efforts, financial difficulties neverthelessarise) honor the market’s strengthened perception.

37. For a more extensive discussion of the propos-

als and the issues underlying them, see W. ScottFrame and Lawrence J. White, “RegulatingHousing GSEs: Thoughts on InstitutionalStructure and Design,” Federal Reserve Bank ofAtlanta Economic Review 89 (Second Quarter,2004): 87–102.

38. For a thorough and broad discussion of thistopic, see U.S. Office of Federal Housing Enter-prise Oversight.

39. See the more extensive discussion of interest-rate risk below.

40. Mortgage insurance is provided by two govern-ment agencies—the Federal Housing Administra-tion and the Department of Veterans Affairs—aswell as by private mortgage insurers.

41. See Inside Mortgage Finance, The 2003Mortgage Market Statistical Annual, Volume II: TheSecondary Mortgage Market, (Bethesda, Maryland:Inside Mortgage Finance Publications, 2003).

42. The stress tests that OFHEO uses to deter-mine the risk-based capital requirements for thetwo GSEs take two years from the depression thatthe “oil patch” experienced in the 1980s, and thenextends that environment over a 10-year horizon.

43. See, for example, Eugene Ludwig, “SystemicRisk: A Regulator’s Perspective,” Fannie Mae Papers 2,no. 1 (February 2003), http://www.fanniemae.com/commentary/pdf/fmpv2i1.pdf; Noel Fahey,“Systemic Risk: A Fannie Mae Perspective,” FannieMae Papers 2, no. 2 (February 2003), http://www. fanniemae.com/commentary/pdf/fmpv2i2.pdf; andFranklin Raines, “Remarks,” Panel on GovernmentSponsored Enterprises, 40th Annual Conference onBank Structure and Competition, Federal ReserveBank of Chicago, May 6, 2004, http://www.fan-niemae.com/media/speeches/speech.jhtml?repID=/media/speeches/2004/speech_242.xml&counter=1&p=Media&s=Executive percent20Speeches.

44. See, for example, Dwight Jaffe, “The InterestRate Risk of Fannie Mae and Freddie Mac,” Journalof Financial Services Research 24 (August 2003): 5–29;Alan Greenspan, Testimony before the Committeeon Housing and Urban Affairs, U.S. Senate,February 24, 2004, http://www.federalreserve.gov/boarddocs/testimony/2004/20040224/default.htm; and William Poole, Remarks before the Panelon Government Sponsored Enterprises, 40thAnnual Conference on Bank Structure andCompetition, Federal Reserve Bank of Chicago,May 6, 2004, http://www.stlouisfed.org/news/speeches/2004/05_06_04.html.

45. Again, as a back-of-the-envelope calculation,the estimates of the federal government’s contin-

20

gent liability could be capitalized to imply about$150 billion of loss (which would break down toabout a 5–6 percent loss on the two companies’portfolios and about a 4 percent loss on theirMBS). This latter number is consistent with theexperience of the Resolution Trust Corporation,the government agency created in 1989 to resolvethe financial problems of the insolvent S&Ls ofthe late 1980s and early 1990s. The RTC’s experi-ence was that single-family residential mortgageloans in the portfolios of insolvent S&Ls had loss-es of only about 4 percent. See Fahey.

46. See Charles Kulp, “Assessing the BankingIndustry’s Exposure to an Implied GovernmentGuarantee of GSEs,” FYI, Federal DepositInsurance Corporation, March 1, 2004, http://www.fdic.gov/bank/analytical/fyi/2004/030104fyi.html.

47. These percentages for the aggregate of alldepositories equivalently represent simple aver-ages. There is variation around these averages. TheKulp report notes that 3 percent of depositoryinstitutions hold GSE debt-plus-MBS that exceed500 percent of their “Tier 1 capital”; these 3 percentaccount for 4 percent of all depositories’ assets.

48. Or whether it might instead also be stressed byimperfectly informed investors who begin to shyaway from its debt and MBS.

49. It seems likely that the Federal Reserve wouldtreat the impairment of one of the GSEs as anevent worthy of special actions, such as assuringthe financial markets that it would be ready toprovide adequate liquidity, as needed, withoutnecessarily involving a Fed “bailout” of theimpaired GSE.

50. This sixth initiative was rendered moot in2002 when OFHEO’s risk-based capital standardbecame effective.

51. Suggestions for further improvement can befound in Frame and Wall, and in Jaffee.

52. The average term for a new mortgage has hov-ered at about 27–28 years over the past decade;adjustable-rate mortgages have been less than aquarter of the market in the last 6–7 years andexceeded a third of the market in only a singleyear of the 1990s. I am not aware of data thatdescribe the proportion of fixed-rate mortgagesthat are prepayable without penalty, but it mustbe high, since those are virtually the only kinds ofmortgages that Fannie Mae and Freddie Mac willbuy. In the language of finance, the borrower hasa free call option to prepay.

53. This will depend on the borrower’s awareness

of refinancing possibilities, the transactions costsof refinancing, the borrower’s expectations aboutthe direction of future interest-rate changes, andany changes in the borrower’s personal situation(or changes in the value of the property) thatcould affect the lender’s likelihood of grantingthe new loan.

54. There may be some compensating upwardadjustment in home prices in response to thedecrease in interest rates, but the net effect is like-ly to be in the direction indicated in the text.

55. The exception will be the borrower whose per-sonal financial situation has improved and whocan lower his or her interest rate even in a risingmarket.

56. Again, there may be some counterbalancingmovement in home prices, but the net direction islikely to be as described in the text.

57. This phenomenon of additional adverse effectson the mortgage lender from decreases or increas-es in interest rates is usually described as the “neg-ative convexity” of the mortgage instrument.

58. There are some lenders that, when permittedto do so, do include prepayment penalties.

59. This is true for a closed economy (which is arough approximation of the environment of resi-dential mortgages). If mortgages were traded in aglobal financial environment but national inter-est-rate movements were not perfectly correlated,then some hedging of national interest-rate riskmight be possible.

60. The borrower still bears some risk, in the sensethat a subsequent change downward in interestrates means that the borrower could have subse-quently borrowed at a lower cost.

61. For a contrary view, see Susan E. Woodward,“Rechartering Freddie and Fannie: The PolicyIssues,” Sand Hill Econometrics, Menlo Park,California, 2004, mimeo. Also, in June 2004Freddie Mac ran prominent newspaper adsextolling the advantages of 30-year fixed-ratemortgages without prepayment penalties andlinking their existence to the special GSE status ofFannie Mae and Freddie Mac. See, for example,Wall Street Journal, June 24, 2004, p. A17.

62. Dennis W. Carlton, David B. Gross, and RobertS. Stillman, “The Competitive Effects of FannieMae,” Fannie Mae Papers, 1, no. 1 (January 2002),http://www.fanniemae.com/global/pdf/commentary/fmpv1i1.pdf.

63. As a theoretical matter, however, one cannot

21

rule out the possibility that these rich returns werecaused by “Bertrand” competitive behavior—where-by each firm focuses myopically on price competi-tion—in the presence of rising marginal costs. Also,it is well known that, in the context of differentiat-ed products, even Bertrand behavior can yield rents.

64. For the 15 years 1988–2002, Fannie Mae aver-aged 27.5 percent, while Freddie Mac averaged23.5 percent.

65. See U.S. Congressional Budget Office,“Updated Estimates of the Subsidies to theHousing GSEs,” April 8, 2004.

66. See Woodward.

67. See Robert Van Order, “A MicroeconomicAnalysis of Fannie Mae and Freddie Mac,”Regulation 23 (Summer 2000): 27–33; Robert VanOrder, “The U.S. Mortgage Market: A Model ofDueling Charters,” Journal of Housing Research 11,no. 2 (2000): 233–55; and Robert Van Order, “TheEconomics of Fannie Mae and Freddie Mac,” inServing Two Masters, yet out of Control: Fannie Maeand Freddie Mac, ed. Peter J. Wallison (Washington:AEI Press: 41–54).

68. The same outcome should be sought for theother housing GSE, the FHLB system.

69. Are the two companies so large that the finan-cial markets would believe that, even if they werefully privatized, the federal government wouldnot take the risk that their financial difficultieswould cause systemic risk and undue disrup-tion—that they are “too big to fail”? That couldnot be known before the event. But what doesseem likely is that any such belief would be weak-er than the current belief in the implied guaran-tee. Further, to the extent that their reduced bor-rowing advantages in debt markets and in MBSmarkets cause their shares of involvement in resi-dential mortgage finance to shrink, the systemicrisks that their financial problems could causewould also shrink.

70. A good start is the American DreamDownpayment Act of 2003, which authorizes $200million annually to help low- and moderate-income homebuyers.

71. Though the two companies do not currentlycreate “bankruptcy-remote” trusts for the MBS, itis highly likely that they would do so after theywere truly privatized. In this event, the loans-to-one-borrower limitations should not apply to the

two companies’ MBS, since the MBS representpools of underlying mortgages on which the twoGSEs have offered their guarantees. The MBS thusrepresent however many mortgage borrowers arein any given pool and should not (if they are in abankruptcy-remote trust) be treated differently(from the perspective of the loans-to-one-borrowerrule) from any other portfolio of mortgages.

72. See, for example, Brink Lindsey, Mark A.Groombridge, and Prakash Loungani, “Nailingthe Homeowner: The Economic Impact of TradeProtection of the Softwood Lumber Industry,”Cato Institute Trade Policy Analysis no. 11, July 6,2000; http://www.freetrade.org/pubs/pas/tpa-011es.html. Another example is the current set ofrestraints on imports of cement from Mexico; see,for example, “Florida’s Cement Shoes,” Wall StreetJournal, August 18, 2004, p. A10.

73. See Edward L. Glaeser and Joseph Gyourko,“The Impact of Zoning on Housing Affordability,”NBER Working Paper no. 8835, March 2002.

74. This would be comparable to the FederalReserve’s decision to cease their “daylight over-drafts” and treat them like other financial institu-tions, as noted above.

75. Currently, the two GSEs must meet the follow-ing goals: 50 percent of each company’s businessmust benefit low- and moderate-income families,31 percent must benefit underserved areas, and 20percent must serve “special affordable housing”needs. As of July 2004, HUD was considering revi-sions to these targets that would raise them to 57percent, 40 percent, and 28 percent, respectively, aswell as adding requirements that would establishtargets related to first-time buyers and to home-purchase loans (as compared to purchasing sea-soned loans or refinancings). See U.S. Departmentof Housing and Urban Development, “Summary:HUD’s Proposed Housing Goal Rule—2004,” April7, 2004, http://www.hud.gov/offices/hsg/gse/summary.doc.

76. Indeed, the two companies are likely to facegreater competition from an expansion of theFHLB system and from changed rules withrespect to banks’ capital requirements for holdingmortgages. This increased competition is likely toerode some of their franchise value and therebyerode some of their implicit capital and increasetheir incentives to take risks. For an elaborationof this argument, see W. Scott Frame andLawrence J. White, “Competition for Fannie Maeand Freddie Mac?” Regulation, forthcoming.

22

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