Facing Facts on Fannie and Freddie

In the year since it was passed by the Senate Banking Committee, legislation to reform the regulation of Fannie Mae and Freddie Mac has languished in the Senate.

Headshot of Resident Fellow Peter J. Wallison
Resident Fellow Peter J. Wallison

The problem, we’re told, is that Senate Democrats do not like the provision of the bill that would severely restrict Fannie and Freddie's accumulation of portfolios of mortgages and mortgage-backed securities.

These portfolios now amount to almost $1.5 trillion and are carried with debt almost equal to that amount, requiring Fannie and Freddie to assume enormous interest rate risk. Those who favor restrictions on the size of the portfolios argue that this risk, if not well managed, could adversely affect the financial condition of one or both of these organizations, with a resulting big hit to the economy and an enormous taxpayer bailout.

Instead, proponents of portfolio limitations note that Fannie and Freddie can carry out all their secondary-market activities simply by creating and issuing mortgage-backed securities, a process that does not require them to take interest rate risk.

Until recently, the Democrats on the Banking Committee had never made clear why they opposed restrictions on the size of the portfolios. But now, in a recent statement of "Additional Views," they have finally declared their reasons for holding up the committee bill.

The Democratic senators reported, "The retained portfolios of Fannie Mae and Freddie Mac help keep interest rates low; they have helped markets function effectively, even when other sectors experienced severe credit crunch problems; and they attract funds from all over the world to be invested in the U.S. mortgage markets." Perhaps not surprisingly, this is exactly what Fannie and Freddie have been saying in their intensive lobbying campaign to fight restrictions on their highly profitable mortgage portfolios.

Trouble is, none of it's true. In a paper posted this week on the Federal Reserve Board's Web site, and in a slide presentation used at a conference at the Chicago Federal Reserve Bank in May, three Fed economists demolished the first two of these reasons; the third was demolished a year ago.

Do Fannie and Freddie's portfolios of mortgages and mortgage-backed securities keep interest rates low? No, according to the Federal Reserve economists. Reviewing the actual impact on mortgage interest rates of the two companies' purchases of mortgages and mortgage-backed securities, the economists could find a difference of only two basis points (1/50th of 1%) attributable to the activities of Fannie and Freddie. So their purchasing activities, the Fed economists concluded, "have economically and statistically negligible effects on mortgage rate spreads." In other words, they noted, the effect on interest rates was "not statistically different than zero."

Have Fannie and Freddie helped markets function effectively, when other sectors experienced severe credit crunch problems? No again. If their purchases of mortgages and mortgage-backed securities during the 1998 credit crunch had any effect in stabilizing the market, it would have shown up in moderated interest rates. But while the two purchasers bought these investments during this period--as profit-maximizers would--their purchases again had no significant effect on interest rates, according to the Fed economists. So, they note, the Fannie and Freddie "portfolios do not influence rates either in normal or abnormal times."

Well, then, do Fannie and Freddie's portfolios attract foreign funds to the U.S. residential mortgage markets? Nope. The Fed economists did not deal with this question, but a front page article in the Wall Street Journal almost one year ago was headlined “Housing-Bubble Talk Doesn't Scare Off Foreigners; Global Investors Gobble Up Mortgage-Backed Securities, Keeping Prices Strong."

The article noted that "overseas investors are the fastest-growing source of demand. ... The foreigners' holdings rose 26% last year and have continued to bound ahead so far this year." In other words, Fannie and Freddie's portfolios--and the debt issuance they entail--are not necessary to attract foreign investment to the U.S. residential mortgage market. They can attract the same foreign investment simply by issuing mortgage-backed securities--in which case, they don’t have to take the interest rate risk associated with holding a portfolio of mortgage obligations.

The Fed economists agree that issuing mortgage-backed securities rather than accumulating and holding portfolios of mortgages is the right course for Fannie and Freddie.

Summing up their views, they note that Fannie and Freddie could perform their missions without issuing the debt that's necessary for them to acquire their huge mortgage portfolios. Instead, they can simply issue the securities, which do not require them to take the interest rate risk that is the basis of the enormous risks they create for the taxpayers and the economy.

To use a current cliché, these are inconvenient facts. But will they make any difference to the Senate Democrats? John Maynard Keynes was once chided for changing his views, to which he is said to have replied, "When the facts change, sir, I change my mind. What do you do?"

Peter J. Wallison is a resident fellow at AEI.

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