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Housing Giants Pose Risks

This is an excerpt from an article the three economists from the Federal Reserve Bank of St. Louis wrote for the Bank's quarterly publication, The Regional Economist. The full article about Fannie Mae, Freddie Mac and the Federal Home Loan Bank System can be found at www.stlouisfed.org.

All three housing GSEs obtain funding by selling debt instruments in the capital markets. Outstanding debt of the three GSEs at year-end 2003 exceeded $2.4 trillion, compared with publicly held debt of $4 trillion for the federal government. Because of the size of this outstanding debt, much of which is held by U.S. depository institutions, a loss of confidence in Freddie Mac, Fannie Mae or the FHLBanks could send shock waves through the financial system.

Therefore, the capital markets have concluded that the federal government most likely would not permit a default. This conclusion is not irrational. The federal government bailed out another government-sponsored enterprise, the Farm Credit System, in the 1980s.

Although circulars for housing-GSE debt warn that the instruments do not carry the full faith and credit of the U.S. government, the small yield spreads over comparable Treasury debt suggest that investors believe otherwise. Estimates of the value of the reduced funding costs vary.

One recent study concluded that it produced an average of a 40-basis-point (0.4 percent) reduction in the interest rate on Freddie and Fannie debt between 1998 and 2003.

In part because of implicit default guarantees, the housing GSEs have been extremely profitable in recent years. Fannie Mae earned net income of $7.9 billion during 2003, while Freddie Mac earned $10.1 billion during 2002 (latest year available) - sufficient to generate returns on equity well above 25% in each case.

The FHLBanks are cooperative institutions. Their profit figures are not as meaningful because part of the profit is distributed to members in the form of low-cost services. Bank and thrift membership in the FHLB System is growing, however, indicating that its owner-members find the combination of services and dividends quite valuable.

When a firm can take risks, enjoy the full benefits and avoid the full costs, economists say a moral hazard is present. The hazard is that the firm will respond to these incentives by increasing risk to imprudent levels. Moral hazard is a problem for the housing GSEs.

Because the capital markets view their debt as virtually free of default risk, Freddie, Fannie and the FHLBanks can enjoy all the upside of risk-taking and little of the downside. Unlike truly private firms, housing GSEs need not pay higher interest rates when they ramp-up risk because the markets believe the federal government guarantees the debt. The burden of the extra risk does not, of course, go away just because the housing GSEs do not bear it. Indeed, taxpayers ultimately would bear the extra risk if the federal government were to stand behind a failing GSE.

Taxpayer exposure to risk-taking by housing GSEs is not limited to potential losses from default. Risk-taking by housing GSEs could undermine the stability of the financial system because so many banks depend on them for liquidity. Commercial banks hold more than one-half of their securities portfolios - a key source of emergency liquidity - in the form of mortgage-backed securities and GSE debt. Moreover, the portion of commercial bank loans backed by real estate is at an all-time high.

Banks are comfortable holding mortgage-related securities because these securities can be sold quickly with minimal transaction costs, and banks are comfortable holding real estate-backed loans because these loans can be pledged against advances from the FHLBanks or sold to Freddie or Fannie.

A severe shock to one or more of the housing GSEs could lead to a market lockup, in which investors become reluctant to hold GSEs' direct or indirect obligations. This could, in turn, lead to a temporary suspension of mortgage purchasing, mortgage securitizing or mortgage "advancing," thereby forcing the Federal Reserve to intervene to re-liquefy the mortgage markets.

Who actually benefits from the subsidy-homeowners or the employees and shareholders of GSEs? As noted, the implicit guarantee against default lowers housing-GSE funding costs. Lower funding costs can be used to reduce mortgage rates for homeowners or to raise employee salaries or dividends for housing-GSE shareholders. Estimates vary about the division of the subsidy; one recent study estimated that the subsidy to Freddie and Fannie lowered mortgage interest rates by about 7 basis points (0.07 percent), yielding a savings to homeowners of about $44 billion.

Of the three housing GSEs, the FHLBanks are the least likely to increase their own risk. The shareholders of the 12 regional FHLBanks are also the customers. Therefore, the cost of excessive risk-taking by an FHLBank would fall on the same parties that enjoy the benefits. Still, the FHLB System may create moral hazard through another channel by implicitly encouraging its members to ramp up risk.

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