Sunday, May 9, 2010

Fannie Mae and Freddie Mac

This piece in the Sunday New York Times draws attention to Freddie Mac's first-quarter 2010 financial report, and raises questions about the unaddressed problems related to Freddie Mac and Fannie Mae vis-a-vis the proposed Congressional financial reform package.

As background, recall that Fannie Mae (Federal National Mortgage Association) has been with us since 1938. Originally created as part of the federal government, it was moved off the government's balance sheet in 1968 and made a private corporation. Freddie Mac (Federal Home Loan Mortgage Corporation) was created in 1970 with a structure and role very similar (if not identical) to Fannie Mae's. In September 2008, Fannie Mae and Freddie Mac became wards of the government, under the "conservatorship" of their regulator, the Federal Housing Finance Agency (FHFA). The FHFA was in turn created in July 2008, with the powers it needed to subsequently take over Fannie Mae and Freddie Mac as conservator.

What do Fannie Mae and Freddie Mac do? First, they securitize mortgages. Mortgage loan originators sell loans to Fannie and Freddie, and they repackage these loans as mortgage-backed securities (MBS), which they then sell. This does not create any assets and liabilities on Fannnie or Freddie's balance sheets, except for the short-term financing required while these agencies are packaging the MBS. Second, Fannie and Freddie have a mandate to buy and hold mortgages and mortgage-related assets. These assets could be mortgages purchased directly from the orginators, or on the secondary market, MBS issued by other financial intermediaries, or mortgage-related derivatives. In order to buy mortgages and mortgage-related assets, Fannie and Freddie issue agency securities - i.e. long-maturity debt.

Fannie Mae and Freddie Mac are huge. Fannie reports that, in September 2009, 27.5% of U.S. residential mortgage debt was either held directly by Fannie, or was somehow incorporated in Fannie MBS. Assuming Freddie is of comparable size (and I'm pretty sure it is), these two agencies have something to do with about half of the residential mortgage debt in the US.

Now, it has been known for a long time that the agency debt issued by Fannie Mae and Freddie Mac enjoys the implicit backing of the federal government. I first learned this as a teaching assistant in Don Hester's University of Wisconsin-Madison undergraduate money and banking class in 1980. The implicit backing was made explicit in September 2008, and the two agencies have subsequently received capital infusions from the US government, to the tune of $59.9 billion for Fannie and $52 billion for Freddie.

Fannie and Freddie, like all other large US financial institutions (except Lehman Brothers, apparently), have been treated as too big to fail. I don't know how the antecedents of the FHFA regulated Fannie and Freddie, but it is abundantly clear that they were doing a bad job. Fannie and Freddie, with the benefit of undue political influence, became bloated, inefficient, and corrupt institutions that took on too much risk.

The New York Times article points to recent losses on Freddie's portfolio, and asks an interesting question, which is: "How do Freddie and Fannie determine what they pay for the mortgages they buy?" The answer is the following:
Michael L. Cosgrove, a Freddie spokesman, declined to discuss what the company pays for the mortgages it buys. “We are supporting the market by providing liquidity,” he said. “And we have longstanding relationships with all the major mortgage lenders across the country. We’re in the business of buying loans, and we are one of the few sources of liquidity available.”
If we read between the lines here, the answer seems to be that, since Fannie and Freddie are essentially the only game in town now, they buy mortgages at whatever price they want.

Thus, though Fannie and Freddie account for roughly half of the stock of mortgage activity, they account for most of the recent flow. Further, the Fed was in turn financing most of that activity, until its purchase programs of Fannie and Freddie MBS and Fannie and Freddie agency securities ended in March. Thus, we currently have three-tiered intermediation in the mortgage market, whereby mortgage loans ultimately end up on the asset side of the Fed's balance sheet. How did the Fed determine the prices at which it bought MBS from Fannie and Freddie? Must be the same way Fannie and Freddie determines the prices it pays for mortgages - the prices are whatever the Fed wants.

Now, the MBS currently on the Fed's balance sheet are not junk, but nevertheless the Fed could have paid more than the "market price" for this stuff, and would thus take a loss if it sold these assets now or later. The difference between the price at which these assets are carried on the Fed's balance sheet, and the market value of the assets, is the implicit subsidy the Fed is granting to Fannie and Freddie, and to the housing market.

What should we do with Fannie and Freddie? These institutions suffer from the same moral hazard problems as other too-big-to-fail financial institutions. Without appropriate regulation, Fannie and Freddie will take on too much risk, and they further suffer from the usual bureaucratic bloat of government-owned or government-insured institutions. And what do we get for all this pain? I have argued elsewhere that we should embrace large financial institutions. In spite of the costs of regulation and industry concentration, economies of scale generally win out in the financial industry. However, the same argument does not apply to Fannie and Freddie. These institutions are nothing more than inefficient vehicles for subsidizing the housing market in the United States. If Fannie and Freddie were not there, well-regulated private financial institutions could take over their activities and do it better.


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  2. Steve:

    I think you are wrong on one point. The Fed is not necessarily subsidizing the new MBS flow. It is the treasury that is subsidizing by way of its guarantee of this debt. From the Fed's perspective, these treasury-insured MBS look practically like treasuries. The Fed does not necessarily pay what ever it wants for this de facto treasury debt; it pays the going rate (i.e., the rate on competing treasuries).

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  4. I thought about this a bit, and I'm not convinced. MBS are not "practically like treasuries." A treasury is a claim to a certain stream of future nominal payoffs, whereas the future payoffs on a MBS are uncertain. The debt of Fannie Mae and Freddie Mac, of course, are essentially identical to treasuries with the same maturity. However, since the majority of the mortgage-related assets acquired by the Fed were MBS, let's stick to those. Now, from early 2009 to early 2010, it seems that the Fed was acquiring most of the new flow of MBS from Fannie Mae and Freddie Mac, while Fannie Mae and Freddie Mac were acquiring most of the mortgage debt in the United States, holding some it, and passing on the rest to the Fed as MBS. What determined the price at which the Fed acquired the MBS? There was no market discipline - the Fed determined that price.

  5. Steve:

    To the extent that the stream of future nominal payoffs for MBS are insured by the Treasury, they are essentially equivalent to Treasuries from the perspective of the Fed.

    Nevertheless, I think you are correct that the Fed subsidized these objects by paying above market prices. So, I concede that you are correct.

    (Whether such a subsidy is justified or not, however, depends on your view on whether the market always values such assets "correctly." I think we have seen enough evidence to suggest that the market can, on occasion, misprice assets significantly. Whether this is the case with the new MBS or not, I'm not sure.)

  6. I think you are correct that the Fed subsidized these objects by paying above market prices.

  7. I think you are right, any other financial institution could do the job of Fannie and Freddie better.
    But what can we do? The positions of companies that are supported by the federal government seem to be inviolable.