No one suggests that a bailout looms, but the danger will grow with time because Fannie and Freddie’s debts will grow by hundreds of billions. Their relentless expansion stems partly from their special status as government-sponsored enterprises (GSEs). Although Congress created and blessed them, they’re companies with shareholders (about 400,000 for Fannie and 200,000 for Freddie) and, recently, immense profits–$18.9 billion for Fannie alone from 1999 to 2002. But any doubts about their ability to cover their debts could trigger a crisis.
Of course, Fannie and Freddie say that their profitability shows that they are well run and safe, even while advancing congressionally mandated goals: aiding the nation’s housing markets and increasing homeownership. “We are in the American Dream business,” says Fannie. They advertise an almost-perfect marriage between private enterprise and public purpose.
The boasts aren’t entirely hollow. Fannie and Freddie were intended to improve the flow of money into housing by making mortgage lending more national. When Congress created the present Fannie (1968) and Freddie (1970), mortgage markets were weak and local. People borrowed heavily from banks and savings and loans, whose funds came from local deposits. Some areas had too much credit; some, too little. Credit flows were also unstable. When interest rates rose, housing often suffered as depositors shifted from banks and S&Ls into better-paying investments.
Fannie and Freddie have improved home financing in two ways. First, they borrow to buy mortgages. Because their debt is considered backed by the federal government, borrowing rates are low. Fannie says its 10-year notes average roughly 60 “basis points” above the U.S. Treasury’s (say, 4.6 percent against 4 percent). The idea is to borrow at a low rate and buy mortgages that pay higher rates; profits come from the interest-rate “spread.” Second, Fannie and Freddie guarantee–for a fee–mortgages purchased by others and packaged in “mortgage-backed securities.” If homeowners default, the GSEs promise to pay. (Fannie and Freddie deal only with mortgages up to $322,700, usually with a 20 percent down payment.)
Fannie and Freddie have largely fulfilled their mission. Mortgage markets are more national; sharp swings in housing credit have abated. But paradoxically, Fannie and Freddie are no longer essential for strong housing finance. “Securitization” is now widespread. If the GSEs vanished, mortgages would still be packaged and bought by investors (pensions, insurance companies, banks) just as they already buy riskier securitized credits–credit-card debt and auto loans, for instance. Nor would mortgage rates rise much. Fannie says that most of its advantage in lower rates (the roughly 60 basis points) is passed along to mortgage borrowers. But some economists think the pass-through is much lower, perhaps as low as 20 basis points; that’s a 5 percent loan instead of 5.2 percent.
The danger in tolerating the status quo is that Fannie and Freddie face conflicting taskmasters. Wall Street wants higher profits; Washington wants higher homeownership (the GSEs now have federal goals for making mortgages available to lower-income buyers). One way to resolve the tension is to embrace riskier business strategies. Swings in interest rates already pose a financial hazard. Lower or higher rates can spoil a profitable spread between borrowed and lent funds. Although the GSEs hedge against losses through complex “financial derivatives,” these are not infallible.
A crisis is generally what people don’t expect. The human factor remains a joker. Consider what happened to Freddie this year. Its top executives had to quit because the company underreported its profits by as much as $4.5 billion. They wanted to shift some present profits into the future; the aim was to satisfy Wall Street by showing a smooth rise in earnings. Although the misleading figures didn’t indicate a weaker company, they taught a lesson: big errors can go undetected by outsiders–including regulators–for long stretches.
The odds of Fannie’s and Freddie’s causing a financial crisis may be small. But if one occurred, the consequences could be huge. Even now, about 3,000 U.S. banks hold GSE debt equal to all their capital. The Bush administration is reconsidering its policy toward Fannie and Freddie; the temptation will be to protect the housing market and propose only modest changes in regulation. Far better would be a blue-ribbon commission to ask how these giant enterprises should be refashioned to curb their size and special status. Unbroken they may be; but if they ever do break, the fix could cost a fortune.
