Arthur F. Burns Fellow Peter J. Wallison

Since the scandal surrounding the collapse of their accounting in 2003, the Office of Federal Housing Enterprise Oversight, their regulator, has not allowed either entity substantially to increase the size of its mortgage portfolio. Fannie and Freddie are using the recent market stumble to argue that allowing them to buy and hold more mortgages in their portfolios would "add capital" to the mortgage markets.

Their motives are clear: Holding mortgages is profitable--much more so than creating pools of mortgages and selling mortgage-backed securities (backed by these pools) to investors. The motives of those in Congress and elsewhere for supporting this change in regulatory policy are much less clear, since whatever Fannie and Freddie might do for the beleaguered mortgage markets through purchasing and holding mortgages they can also do through securitization--and with a lot less risk to the taxpayers. It's possible that Fannie and Freddie's supporters don't know this. It's also possible that they do, but prefer to help the companies rather than protect the taxpayers who are the ultimate backers of these government-sponsored enterprises.

When Fannie and Freddie purchase and hold mortgages, they take two kinds of risk. The credit risk--default by the borrower--is obvious. The interest-rate risk sometimes eludes people.

Here's how it works. In order to acquire a portfolio of mortgages, Fannie and Freddie borrow money in the capital markets. Because of their perceived relationship to the government, investors believe--correctly, I think--that the government will bail them out if they get into financial trouble. So the interest rate they pay on the funds they borrow is generally lower than AAA commercial credit, and this means holding mortgages is very profitable.

However, market interest rates move around, while the rate paid on conventional conforming mortgages is generally fixed; and while most mortgages are made for long terms, most Fannie and Freddie borrowings are short term. If they borrow funds at 4% to buy mortgages that pay 5%, they will do quite well. But if the interest rates on the funds they borrow rise to 6%, they'll lose money as long as these remain above the average rate they receive on the mortgages in their portfolios. This is interest-rate risk.

Yet Fannie and Freddie also face interest-rate risk if rates fall. In that case, homeowners tend to refinance their mortgages, and the mortgages in their portfolios are paid off more rapidly than otherwise. Fannie and Freddie can replace these mortgages, of course, but only with mortgages paying less than the original ones. So let's say that the Fannie and Freddie have borrowed funds at 5%, with an average maturity of two years, in order to buy portfolios of 30-year mortgages paying 6%. This time mortgage rates fall to, say, 4%, and homeowners quickly begin to refinance at the lower rate. Now Fannie and Freddie are paying 5% to hold mortgages that are paying 4%--another losing position.

This does not happen if Fannie and Freddie engage only in securitization. In that case, they guarantee to the investors who buy the securities that the mortgages in the securitized pool will pay out at the contracted rate. There is still a risk that interest rates will rise or fall, of course, but this time it is taken by the investors in the mortgage-backed securities, not by Fannie and Freddie and hence not by U.S. taxpayers.

The key question for those who are worried about the condition of the mortgage markets is whether allowing Fannie and Freddie to increase the size of their portfolios will in fact "add capital" to the markets. Here the answer is clearly no.

First, it is debatable whether Fannie and Freddie ever add capital to the mortgage market. The reason is that they borrow almost the same amount as they ultimately use to buy mortgages, so the transaction may be a wash. Funds in; funds out. But even if one believes that by buying mortgages Fannie and Freddie add capital to the markets, the point at which they do so is when they buy mortgages. What they do with these mortgages afterward--whether they hold them in their portfolios or sell them to investors through securitized pools--is irrelevant.

In the end, there is only one major difference between Fannie and Freddie buying and holding mortgages, or buying and securitizing them. When they buy and hold mortgages they are taking big risks for big profits; when they form pools and sell mortgage-backed securities they are taking small risks for small profits.

Those who say they are concerned about the nation's taxpayers should keep this in mind the next time they are told that freeing up Fannie and Freddie's ability to grow their portfolios will add capital to the mortgage markets.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Market Studies at AEI.