Commentary: Fannie and Freddie: Breaking Up Is Good to Do
With congress on the verge of moving oversight of Fannie Mae (FNM ) and Freddie Mac (FRE ) from the obscure Office of Federal Housing Enterprise Oversight (OFHEO) to the Treasury Dept., efforts to rein in the two housing-finance giants are likely to grow. Even Federal Reserve Chairman Alan Greenspan, sources say, joined the chorus of Fannie and Freddie critics last month, when he sought to persuade Treasury Secretary John W. Snow to slow the two companies' growth by calling for an increase in a key capital standard.
Snow demurred. But he did open the door to a tougher capital rule on Sept. 10, when he asked Congress for more flexibility to adjust the standard if needed.
Greenspan may have lost that battle, but he should continue to fight the war. While boosting capital standards is a positive move, the chairman should go a step further and push Congress to break both Fannie and Freddie in two.
The resulting four government-sponsored enterprises (GSES) would carry on the traditional mission of increasing homeownership, especially for low-income and minority families looking for a piece of the American Dream. Having four GSEs would lower the risk of an unexpected financial shock -- and a government bailout.
Why worry about a bailout? The rapid growth and enormous size of the two GSEs is enough to make a regulator sweat. With investors believing that the government will guarantee their debt, Fannie and Freddie pay about 0.30 percentage points less than most banks to borrow. So they borrow like crazy to buy mortgages from banks and thrifts, which are then free to lend again. Then they package loans into mortgage-backed securities (MBS), which they guarantee and sell to investors. They now stand behind about $2.65 trillion of MBS.
RISK MAGNETS. But that's only part of what they do. They also use their access to cheap money to hold in their own investment portfolios the very mortgages that they securitize. In essence, they're putting their eggs into their own baskets, and concentrating mortgage-lending risk instead of spreading it, as they're supposed to do. They now have a combined $1.6 trillion in such investment portfolios, which, to the delight of shareholders, historically produce higher returns than the MBS business.
By breaking up the cozy duopoly, Congress could make the GSEs compete more for mortgages -- and ensure that risk is spread more widely. Fannie itself is the product of a breakup: In 1968, Congress split the Federal National Mortgage Assn. into today's Fannie and Ginnie Mae, a government agency that guarantees Federal Housing Administration and Veterans Administration loans.
However, a breakup solves only half the problem. Together, Fannie and Freddie run a $4 trillion book of business on a tiny capital base of $60 billion. Such leverage raises the specter of a crisis like the one in the 1980s when some 1,400 savings-and-loans had to be closed or merged, at a cost to taxpayers of $200 billion. "Any problem in the capital markets affecting these firms could become very large, very quickly," said William Poole, president of the Federal Reserve Bank of St. Louis, in a March speech. Because of the scale of their obligations, it could happen in "a matter of days, or even hours."
What's really got the Fed worried is that the markets haven't forced the two companies to hold more capital as a cushion against unforeseen shocks. When Freddie forced out three top executives because of an accounting scandal in June, the markets barely reacted. And credit-rating agencies did not lower their ratings. Says a Fed economist: "The mechanism of market discipline has been disabled because investors believe the government will step in and save them."
That's why Greenspan wants the GSEs to hold more risk-based capital -- the amount they need to ride out adverse changes in interest rates or a sudden inability by homeowners to repay loans. Currently, the GSEs must have enough capital to function under severe stress, defined as a sudden 75% increase, or a 50% plunge, in rates. That means $18 billion in risk capital for Fannie, and $4.7 billion for Freddie -- amounts both GSEs easily exceed. Says Fannie Chairman and CEO Franklin D. Raines: "By any measure, we have vastly more capital than the typical bank for the risk we have."
Critics disagree, arguing that capital standards would have to be at least 20% higher, and up to 50% higher for riskier mortgages, to match those of commercial banks. "The GSEs are well-managed by smart people," says a Fed economist. "But that's not the same thing as having adequate capital."
Fannie's and Freddie's narrow specialty gives them one big advantage: They have built up more expertise than most banks in managing risk, especially the risk that homeowners will prepay mortgages. That, Fannie and Freddie argue, means less stringent capital rules should apply to them.
Because of their huge borrowings, Fannie and Freddie must do massive amounts of hedging with derivatives, such as interest-rate swaps. Together, they held more than $1 trillion worth in 2002. That's more than 10% of all such instruments in use by financial institutions. A February OFHEO study concluded that not only might the GSEs' demand for hedges outstrip supply in the near future, but that a financial problem at one GSE could quickly spread to counterparties. At highest risk would be the seven largest derivatives dealers -- J.P. Morgan Chase (JPM ), Citigroup (C ), Goldman Sachs (GS ), Deutsche Bank, (DB ), Lehman Brothers, (LEH ) Merrill Lynch, (MER ), and Morgan Stanley -- that take the other side of 60% of Fannie and Freddie hedges. And in an August study, Fed economists concluded that the hedging needs of the GSEs are so large that they whipsaw the rest of the market and exaggerate movements in interest rates. Says a Fed source: "Greenspan thinks Fannie and Freddie are causing market distortions."
FIONA AND FRANKIE. The solution? Congress could charter two new GSEs and give them seed capital. A new "Fiona Mae" would get half of Fannie's assets and liabilities and half its staff. A new "Frankie Mac," likewise, would inherit half of Freddie's balance sheet and expertise. Divvying up derivatives, some of which do not perfectly match the assets being hedged, is trickier but doable. Congress might have to explicitly guarantee the junior GSEs' debt to get them on their feet. And while the junior siblings might cause some market disruption at first, their benefits would soon be apparent -- more robust competition for mortgages and risk spread four ways instead of two. That way, human error or a fateful management mistake at one -- exactly what sophisticated risk models can't anticipate -- wouldn't drag down the others.
Fannie and Freddie are clearly too big to fail. But their contribution to the civic good is also too important to lose. Breaking them up, and forcing them to hold more capital, would reduce notably the risk of an unexpected shock bringing the whole system down.
By Paula Dwyer
With Rich Miller in Washington