Building the American dream…or nightmare?

Feb 18th 2005
From The Economist Global Agenda

The Fed's chairman, Alan Greenspan, has urged Congress to do something to rein in America's two monster mortgage-finance agencies, Fannie Mae and Freddie Mac, before they put the country's financial system at risk

FANNIE MAE and Freddie Mac, the twin titans of America’s mortgage markets, think of themselves as big, friendly giants. They stand behind the mortgages of around three-quarters of America’s households—they “make home possible,” as Freddie Mac likes to put it. Their circle of friends does not, however, extend to the Federal Reserve and its chairman, Alan Greenspan. On Thursday February 17th, he told Congress that by letting these two agencies grow unchecked, “We are placing the total financial system of the future at a substantial risk.” Very big but not so friendly, these giants could soon loom over America’s financial skyline like Godzilla and King Kong.

Fannie Mae—originally the Federal National Mortgage Association, it now calls itself by its chummy Wall Street nickname—traces its origins to the credit crunch of the Great Depression, and government efforts to help families borrow to buy a home. Fannie Mae, and its smaller cousin, Freddie Mac (the Federal Home Loan Mortgage Corporation), do not lend to budding homebuyers directly. Instead, they buy up the mortgages that other lenders offer, helping local banks and thrifts to distance themselves from the risks involved. Some of these mortgages are then bundled up and sold on: the agencies serve simply as middlemen. But a growing proportion are kept on the agencies’ balance sheets. Between 1997 and 2003, their combined holdings more than trebled, to over $1.5 trillion (see chart). The middlemen have got fatter and fatter.

Why are they so financially retentive? To provide liquidity and stability to the American mortgage market, a Freddie Mac spokesperson told Reuters news agency. To make money, Mr Greenspan told Congress. Though the two agencies are owned by private shareholders, they are widely perceived to enjoy an implicit guarantee from the federal government. This lets the agencies borrow cheaply to buy mortgages, squeezing out any unsubsidised rival which has to stand on its own feet. Whatever the official position, since the two agencies are now so big, the federal government will in fact be forced to bail them out if things ever do go wrong.

How might things run awry? As an asset, mortgages pose three risks: the interest rate can fall, the mortgage can be repaid early, or the homebuyer can default. To cushion themselves against these risks, the two agencies hold a reserve of capital. But in Fannie Mae’s case, this cushion was judged too threadbare by the agency’s main regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). It ordered Fannie Mae to raise its capital cushion by 30%. The two agencies thus stopped adding to their piles of mortgages at quite such a furious rate last year. But once this moment of crisis passes, Mr Greenspan says, the portfolios will grow again.

On Thursday, Mr Greenspan urged Congress to step in and cut the two agencies down to size. If “immediate divestiture” of their mortgage holdings would be too abrupt, their portfolios should nonetheless be slimmed down over several years. His words wiped more than 2% off Fannie Mae’s share price, and 3% off Freddie Mac’s.

The chairman’s words have hurt the two agencies before. Last year, the Fed chairman suggested homebuyers should take out flexible-rate mortgages, rather than fixed-rate. This is questionable advice for homebuyers, but it is unquestionably bad for Fannie Mae and Freddie Mac. Borrowers, who are averse to risk and often overexposed to mortgage debt, pay a premium for the security of a constant stream of interest payments, a premium Fannie Mae and Freddie Mac are happy to pocket.

The implicit guarantee the agencies exploit accounts for half of their stockmarket value, according to Wayne Passmore, an economist at the Fed. But only a small fraction of this subsidy is passed on to homebuyers in the form of cheaper mortgages. The rest is pocketed by the agencies’ shareholders. This is, said Mr Greenspan last year, an “opaque and circuitous” way to subsidise homeownership.

Does homeownership deserve a subsidy at all? Politicians argue that homeowners are better citizens, more committed to their communities. That is partly true: in America, the transaction costs of selling a house can claim up to 10% of the value of the home, leaving people reluctant to pick up and move. But is immobility necessarily a good thing? When jobs move people should follow them. But homeowners, rooted in their neighbourhoods, are also rooted to the spot. They cling to the side of a sinking neighbourhood, long after the jobs have jumped overboard. As Andrew Oswald, an economist at the University of Warwick, in England, points out, West Virginia has one of the highest homeownership rates in the Union; it also tends to have one of the highest rates of unemployment.

Fannie Mae likes to say that “Our business is the American dream”. Homeownership is undoubtedly popular with Americans and their politicians. But if the Fed chairman is right, these two dream-builders should be keeping financial regulators awake at night.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.