Tag: fannie mae

Fannie & China: 2 Birds, 1 Stone

Chinese President Hu Jintao’s visit to Washington brought renewed focus on China’s currency.  It was likely the largest point of discussion between President Obama and President Hu.  I suspect a less public, but related, issue was China looking for some certainty that America would make good on its obligations; after all, China is our largest lender.

What is often missed is the connection between these two issues:  currency and debt.  When China receives dollars for the many goods it sells us, instead of recycling those dollars into the purchase of US goods, it uses that money mostly to buy US Treasuries and Agencies (Fannie/Freddie securities).  These large Treasury/Agency purchases (foreign holdings of GSE debt are over $1 trillion) have the effect of increasing the demand for dollars and depressing that for yuan, resulting in an appreciation of the dollar relative to the yuan.  This connection exposes the hypocrisy of President Obama’s complaints about China currency manipulation - without massive US budget deficits, China would not be able to manipulate its currency to the extent it does.  If the US wants to end that manipulation, it can do so by simply reducing the outstanding supply of Treasuries and Agency debt.

Another solution, which would also do much to end the “implicit guarantees” of Fannie Mae and Freddie Mac, is to take Fannie and Freddie into a receivership, stop the US taxpayer from having to cover their losses, and shift those losses to junior creditors, which include the Chinese Central Bank.  Were the Chinese to actually suffer credit losses on their GSE debt, they would quickly start to reduce their holdings of such.  They might also cut back on Treasury holdings.  These actions would force the yuan to appreciate relative to the dollar.  And best of all, it would end the bottomless pit that Fannie and Freddie have become.  It is worth remembering that even today, under statute, the Federal government does not back the debt of Fannie and Freddie.  It is about time we also teach the Chinese a lesson about the rule of law, by actually following it ourselves. 

Of course this would increase the borrowing costs for Agencies (and maybe Treasuries), but then if China were to free float its currency, that would also reduce the demand for Treasuries/Agencies with a resulting increase in borrowing costs.  We cannot have it both ways.

CBO on Fannie, Freddie and Mortgage Finance Options

Just in time for the holidays, the Congressional Budget Office has released its analysis of the costs and benefits of various alternatives to our current system of mortgage finance, particularly the role of Fannie Mae and Freddie Mac.

The report examines three possibilities:

  1. A hybrid public/private model in which the government provides explicit guarantees on privately issued mortgages or MBSs;
  2. A fully public model in which a wholly federal entity would guarantee qualifying mortgages or MBSs; or
  3. A fully private model in which there would be no special federal backing for the secondary mortgage market.

The report doesn’t really push one option over another, but simply lays out the advantages and disadvantages of each.  Some highlights worth keeping in mind as the debate continues into the new year:

“Relying on explicit government guarantees…would also have some disadvantages…If competition remained muted, with only a few…firms participating in the secondary market, limiting risk to the overall financial system and avoiding regulatory capture could be difficult…federal guarantees would reduce creditors’ incentive to monitor risk. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices and would most likely end up imposing some cost and risk on taxpayers. In addition, a hybrid approach might not eliminate the frictions that arise between private and public missions.”

“Privatization might provide the strongest incentive for prudent behavior on the part of financial intermediaries by removing the moral hazard that federal guarantees create.  By increasing competition in the secondary market, the privatization approach would reduce the market’s reliance on the viability of any one firm. Private markets may also be best positioned to allocate the credit risk and interest rate risk of mortgages efficiently, and they would probably be more innovative than a secondary market dominated by a fully federal agency. Further, privatization would eliminate the tension between public and private purposes inherent in the traditional GSE model.”

It is worth remembering that over the years, the CBO has actually been quite strong in warning against the dangers of the GSE model.  Sadly Congress simply chose to ignore those warnings.  Here’s hoping that the CBO has little more influence on this issue than they’ve had in the past.

Banks Are Lending, but to Whom?

A recurring concern we have heard since the financial crisis erupted is that banks are simply not lending, and that this is holding back economic activity.  If only banks would lend, the economy would grow.  As usual, the truth is a little more complex. 

Unlike in the Great Depression, and despite about 300 bank failures, the balance sheets and deposits of insured commercial banks and thrifts has been steady, if slowly, expanding throughout the financial crisis and recess.  Banks have continued lending during this time; however, they have changed who they are lending to.  Over the last two years we have witnessed a massive shift from lending to the private sector to lending to the public.

The chart below shows banking business lending and bank holdings of U.S. government securities.   The chart suggests that the approximately $500 billion increase in bank lending to Uncle Sam came at the expense of a $400 billion decline in lending to private business.  If one assumes that bank balance sheets have either been stable or increased slightly, then a loan to the government must off-set a loan otherwise made somewhere else.

While its hard to exactly measure the job impact of this reduced business lending, some estimates have been made on the impact of SBA lending.  According to one study, every $41,600 in new small business loans is associated with 1 new job created.   While this number should be taken with a grain of salt, it implies that the $400 billion reduction in business lending has cost over 9 million jobs.  Of course, one might argue that the half-trillion in lending to the govt has created or “saved” some jobs.  Accepting the difficulty of coming up with a reliable estimate, I think its fair to say that on net a few million jobs have been lost due to this shift of lending from the private to the public sector.

Also of interest is that since the financial crisis, and despite the failures of Fannie and Freddie, commercial banks and thrifts have increased their holdings of Fannie/Freddie/Ginnie securities by over $300 billion.

Textbook economics usually teaches that government crowding out of private investment only really occurs when we are near full-employment.  Yet looking at the balance sheets of our commercial banks and thrifts, would suggest that U.S. Treasuries and Agency securities have crowded out significant lending that would otherwise go to the private sector.   But this should come as no surprise, since banks can borrow for close to zero and invest risk-free in government debt, earning a nice spread of 3 to 4 percentage points.

ARMs as Automatic Stabilizers

An argument often heard for keeping Fannie Mae and Freddie Mac, or some sort of subsidy for mortgages, is the desire to keep the 30 year fixed rate mortgage “affordable.” The 30 year fixed certainly has some merits - which borrowers should be willing to pay for - but it also has the downside of reducing the impact of monetary policy in stabilizing the economy.

Generally interest rates go down in a recession and up in an expansion.  Part of this is the reaction of the Federal Reserve, which tends to cut rates in a recession, but part is also the fact that the demand for credit also declines in a recession and increases in an expansion.

If borrowers moved to adjustable rate mortgages, then in recessions they would likely see a reduction in their mortgage rate, resulting in a reduction in their monthly payment, which would increase their disposable income, which itself should have some positive impact on consumption, helping to stabilize a weak economy.

The reverse would work in an expansion.  If the economy became over-heated, interest rates would likely go up, pushing up monthly payments, resulting in reductions in income and consumption.  While of course this would be unpleasant for the borrower, it would have the benefit of moderating a booming economy, reducing the likelihood of inflation and the occurrence of bubbles.

The latter effect would also increase the degree to which consumers care about inflation and demand price stability from the central bank.  Normally, borrowers have an incentive to favor inflation, as it reduces the real value of their debt.  If however, inflation resulted in an increase in their mortgage rate, their preference could switch toward price stability, which would in the long run be better for growth and the overall economy.

While I do not expect the above to settle the debate over the role of the 30 year fixed rate mortgage, we, as a society, should openly and loudly debate its costs and benefits before we simply assume it needs to be subsidized.

If Not Fannie, then Who?

A common defense offered for keeping Fannie Mae and Freddie Mac, or something like them, is that the market simply cannot absorb the same level of mortgage lending without them.  The central flaw in this argument is that Fannie and Freddie themselves must be funded by the market.  So if the financial markets can absorb X in GSE debt, then the financial markets can absorb X in mortgages.

Different market participants currently face different capital requirements for the same assets.  To some extent, Fannie and Freddie were a vehicle for shifting mortgage risk from higher capitalized institutions to less capitalized.  If the Obama administration and bank regulators are serious about closing “regulatory gaps” then all entities backed by the govt, implicit or otherwise, should hold the same capital against the same risks.  In the following I will thus assume that differences in capital requirements behind mortgages are irrelevant.

So to determine who could absorb the GSEs’ buying of mortgages, let’s look at who holds GSE debt.  Of the approximately $5 trillion in GSE debt and mortgage backed securities (MBS), about a trillion is held by commercial banks and thrifts.  Another trillion is held by insurance companies and pension funds.  Close to a trillion is held by mutual funds.  That quickly gets one to 3 trillion.  Households and state/local governments also hold close to a trillion.  That leaves us with about a trillion left, held mostly by foreign governments (usually central banks).  For this analysis, I am using data pre-Federal Reserve purchases of GSE debt/MBS.

Given that banks hold about a trillion in excess reserves and over 9 trillion in deposits, I think its fair to assume commercial banks could easily absorb another $1 trillion in mortgages, as represented by foreign holders.   Some holders of GSE debt are legally prohibited from holding mortgages.  These entities can generally hold bank commercial paper (think mutual funds) which could then fund the same level of mortgages.  

The point here should be clear, by swapping out GSE debt for mortgages, our financial markets have sufficient capacity to replace Fannie and Freddie.  In fact, we are the only advanced country that does not fund our mortgage market primarily or exclusively with bank deposits.  This analysis also does not assume any reduction in the size of our mortgage market, which should actually be an objective of reform.  We devote too much capital to mortgages, at the expense of more productive sectors of our economy.

A Fannie Mae for Intrastructure?

Like President Bush before him, Obama has a knack for taking the worst ideas of his opponents and making them his own.  It is truly bipartisanship in the worst of ways (think Sarbanes-Oxley, the TARP or No Child Left Behind).  The newest example is the President’s proposed “infrastructure bank.”  A bill along those lines was introduced a few years ago by then Senator Hagel, although the idea is far from new.

First, let’s get out of the way the myth that we have been “under-funding” intrastructure.  Take the largest, and usually most popular, piece:  transportation.  Over the last decade, transportation spending at all levels of government has increased over 70 percent.  One can debate if that money has been spent wisely, but there’s no doubt we’ve been spending an ever-increasing amount on infrastructure - so there goes one rationale for an infrastructure bank.

The real rationale for an infrastructure bank is to transfer the risk of default away from investors, bankers and local/state governments onto the federal taxpayer, but to do so in such a manner that the taxpayer has no idea what they are on the hook for.

If there are truly great projects out there that will pay their own way, then they should have no trouble getting private funding.

Of course, we will be told that the bank will charge an interest rate sufficient to cover losses and that the taxpayer won’t be on the hook.  Again, if it is charging an appropriate rate, then why does the bank need to be chartered (and backed) by the taxpayer?  We’ve heard this story before…with Social Security, flood insurance, FHA, Fannie/Freddie…the list goes on, that all of these programs would pay their own way and never cost the taxpayer a dime.  If there are truly outstanding infrastructure needs, then appropriate the money and pay for them.  An infrastructure bank is just another way to allow Wall Street to line its pockets while leaving the risk with the taxpayer.  If bankers aren’t willing to actually take the risks, then why exactly do we need them?

Mortgage Finance around the World

As the debate on the future of Fannie Mae and Freddie Mac heats up, a useful exercise is to ask how does the U.S. system of mortgage finance compare to other countries, with the obvious caveat that there are a lot of differences to account for. 

A good place to start is a recent working paper by Michael Lea at San Diego State University.  The first observation from Dr. Lea’s paper is that several countries, with far less government involvement in the mortgage market, have comparable, if not higher, homeownership rates than the United States.  These countries include Australia, Ireland, Spain, the United Kingdom and Canada.  He also found that countries with less government support of their rental markets also have higher ownership — not surprising since higher rental subsidies would discourage ownership.

Other differences:  the United States and Denmark are the only developed countries where the predominate type of mortgage is a long-term, fixed rate.  Most countries have variable rate or fixed rate for shorter periods. For instance in Germany, many mortgages offer a fixed term for 10 years, then either adjust or roll-over. 

The United States is also almost alone in having no prepayment penalties and no recourse.  Where a mortgage is recourse, the lender is not limited to collecting just on the house but can go after a borrowers’ income or other assets.  So apparently, in the rest of the World, a borrower is expected to pay his mortgage regardless of the value of his house.

In most other countries, even those with comparable homeownership rates, most funding for mortgages is via bank deposits.  That is surprising given how often I’ve heard it claimed that you can’t rely on just deposits to fund the mortgage system. Somehow the rest of the world manages to do so.

That’s just a few of the interesting comparisons in Lea’s paper.  It is an easy read and has some great charts and tables.