WORD ON THE STREET: Federal housing policies related to the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, have proved costly not only to the federal taxpayer, but also to the broader financial system. We should recognize their failure and move toward a U.S. mortgage market without these finance GSEs.
Fannie Mae was originally chartered in 1938 as the Federal National Mortgage Association. Freddie Mac, the Federal Home Loan Mortgage Corp., was created in 1970. These institutions have grown significantly in size and scope in the U.S. mortgage market since their origination. Their asset holdings – either through mortgage securitizations or direct portfolio holdings – have increased from approximately 7% of total residential mortgage market originations in 1980 ($78 billion) to about 47% in 2003 ($3.6 trillion).
By 2010, Fannie Mae and Freddie Mac owned or guaranteed approximately half of all outstanding mortgages in the U.S., including a significant share of subprime mortgages, and financed 63% of new mortgages originated in that year. Other federal agencies, including the Federal Housing Finance Agency (FHFA) and Department of Veterans Affairs, guarantee approximately an additional 23% of residential mortgages. This means that federal taxpayers guarantee approximately 90% of all new mortgage originations in the current market.
Fannie Mae and Freddie Mac were placed into federal conservatorship under regulatory authority conferred to the FHFA in the Housing and Economic Recovery Act (HERA) of 2008. These institutions faced a combined loss on net income of $108 billion in 2008 on defaulted mortgage assets in their respective portfolios, and the federal government provided the capital to cover the losses. The net loss to federal taxpayers has been $143 billion – $188 billion in transfers from the federal government less $45 billion in dividend payouts from the GSEs.
Moreover, now that Fannie Mae and Freddie Mac fall within federal conservatorship, their combined agency debt, mortgage, and mortgage-related holdings are directly guaranteed by the federal government. The federal government provides direct financing, and the agency debt is not considered official government debt – therefore not included in the accounting of federal publicly held debt. The level of agency debt is massive and has exploded over the last 40 years: In 1970, agency debt as a share of U.S. Treasury debt was 15%, and as of 2010, this share was 81% (a combined $7.5 trillion).
Prior to FHFA conservatorship and the explicit backing of the federal government, market purchasers of the GSE debt believed that Fannie Mae and Freddie Mac's agency debt was implicitly backed by the federal government. This belief stemmed from the many borrowing, tax and regulatory advantages not conferred to any other shareholder corporation.
First, these two housing finance GSEs were exempt from many state investor protection laws and received specific federal charters, mainly issuances of mortgage credit to income-specific groups of households. Second, Fannie Mae and Freddie Mac were exempt from state and local income taxation.
Third, they were exempt from Securities and Exchange Commission registration and bank regulations on security holdings. Fourth, they held a direct line of credit with the U.S. Treasury, issuing agency debt and borrowing between corporate AAA credit interest rate yields and U.S. Treasury interest rate yields. Last, they received U.S. agency status and the guarantee of the federal government on mortgage-backed securities.
The annual estimated value of these subsidy benefits is substantial, ranging from about $7 billion to $20 billion before FHFA conservatorship. This subsidy value translates into an estimate between 20 and 50 basis points (bps) on mortgage interest rates, a share of the value passed through to the shareholders of these firms and a share passed through to mortgage holders.
Economists have made several attempts to estimate the value of these federal subsidies. The Congressional Budget Office estimates that agency debt subsidy (lower borrowing costs) results in a 41 basis-point value to shareholders and borrowers. Fannie Mae and Freddie Mac pass through 25 bps of the subsidy value to borrowers, and shareholders retain an estimated 16 bps on each dollar of debt. These economists estimate a subsidy value on mortgage-backed securities at 30 bps, where approximately 25 bps are passed to the borrowers of mortgages.
Additionally, Wayne Passmore and his co-authors estimate a 40 basis-point subsidy to GSE debt. They estimate that the pass-through of the GSE debt subsidy lowers mortgage rates to homeowners by 7 bps, or 16% of the total 40 basis point subsidy value.
Removing the GSEs
The cessation of activity by Fannie Mae and Freddie Mac would effectively translate into a removal of an interest rate subsidy. Recent research by analysts at the Heritage Foundation indicates that removing this subsidy would have minimal effect on the U.S. housing market and the U.S. economy more broadly. This line of research encompasses three studies that estimate the impact of removing the GSE interest rate subsidy on housing starts, home prices, and overall homeownership. In a final study, we estimate the economic effect of eliminating the subsidy.
The Heritage studies on housing starts, home prices and homeownership indicate that changes in the housing market are more responsive to changes in overall economic fundamentals (e.g., personal income levels, real output, level of household debt, etc.) relative to changes in interest rates or certain credit approval requirements, such as down payment levels. Once the housing and financial markets recover from the recent turmoil, shutting down Fannie Mae and Freddie Mac would have, at most, a minimal impact on the overall housing market.
Additionally, our research studies the likely impact of removing the interest rate subsidy in a macroeconomic framework. Opponents of eliminating GSEs in the housing finance industry assert that phasing out the GSEs would leave the housing market and economy worse off.
Heritage research suggests, however, that eliminating Fannie Mae and Freddie Mac would have a minimal and predictable impact on these markets and the overall economy. The average annual decline in real output over the 10-year forecast period is 0.04%, or a $6 billion average difference from baseline levels, smaller than the estimated average annual subsidy value to these institutions and far less than the average annual cost of these institutions to the federal taxpayer. Thus, claims of drastic economic effects are overstated.
After more than three decades of experience with boom and bust cycles in the housing market – which have affected not only household income and wealth, but also financial markets – federal policymakers should seriously reconsider the federal government's role in shaping housing policy through GSEs such as Fannie Mae and Freddie Mac. These institutions distort the U.S. housing and mortgage markets at substantial risk to households and U.S. taxpayers.
Eliminating the present role Fannie Mae and Freddie Mac play in the U.S. mortgage market could save billions of taxpayer dollars in the U.S. mortgage market through eliminating the subsidy that has induced U.S. households to take on more debt-related consumption, ending up underwater. Many households were never in position to handle such debt; therefore, subsidizing them to become homeowners is not only inconsequential in raising homeownership, but also detrimental to the financial market.
The housing finance GSEs played a central role in the systemic nature of the collapse of the financial market. It is necessary to learn from the failures of this institutional model and restore properly aligned incentives to the U.S. housing and housing finance markets.
Congressional leaders made the mistakes of creating Fannie Mae and Freddie Mac and subsidizing their activity in the U.S. mortgage market through special access to federal funds and an implicit guarantee prior to federal conservatorship in 2008. They need to wind down the GSEs and establish a U.S housing finance market free of the distortions this institutional arrangement generates.
John L. Ligon is a policy analyst in The Heritage Foundation's Center for Data Analysis. This article is adapted and edited from testimony delivered before a recent hearing of the House Financial Services Committee. The original text is online.
