FANNIEMAE&FREDDIEMAC:NEXTSTEPSACASE&PLANFORPRIVATIZATION

Report to the Federal Reserve Bank of Cleveland

March 2009

Haig Panossian

Candidate for Master in Public Policy 2009

John F. Kennedy School of Government, Harvard University

Advisor: Professor Akash Deep

1

CONTENTS

EXECUTIVESUMMARY 2

INTRODUCTION 5

METHODOLOGY 7

BACKGROUND&CONTEXT 9

CREATION:ORIGINALMISSION&OPERATIONALFEATURESOFFANNIEANDFREDDIE 9

GROWTH:RAPIDEXPANSIONOFFANNIEANDFREDDIE 11

CURRENTCHANGES:FINANCIALTROUBLES&GOVERNMENTCONSERVATORSHIP 16

FINANCIALTROUBLES 16

GOVERNMENTCONSERVATORSHIP 19

FUTURE:STRUCTURALREFORMOFFANNIEANDFREDDIE 20

FINDINGS 22

GSESTRUCTUREISNOTANAPPROPRIATEMECHANISMTOPURSUEPUBLICHOUSINGGOALS 22

FANNIEANDFREDDIEPROVIDELIMITEDPUBLICBENEFITSUNDERGSESTRUCTURE 25

GSESTRUCTUREUNNECESSARYTOSERVEFANNIEANDFREDDIE’SPUBLICMISSIONS 34

PRIVATIZATIONISOPTIMALANDFEASIBLELONG­TERMOPTIONFORFANNIEANDFREDDIE 38

RECOMMENDATIONS 55

SHORT­TERMFOCUS:MORTGAGEMARKETSTABILITY 55

PRIVATIZEFANNIE&FREDDIEBASEDONHOLDINGCOMPANYMODEL 57

PURSUEAFFORDABLEHOUSINGGOALSTHROUGHOTHERMEASURES 59

CONCLUSION 60

BIBLIOGRAPHY 61

APPENDIX 65

2

EXECUTIVE SUMMARY

The Fannie Mae-Freddie Mac crisis may have been the most avoidable financial crisis in

history.1 For years before the crisis, critics warned about the macroeconomic risks and potential

taxpayer costs of these two housing government-sponsored enterprises (GSE) due to their GSE

status. Nevertheless, due to the “off-budget” nature of Fannie and Freddie’s costs to taxpayers,

effective lobbying, and a broad perception that housing GSEs were valuable and cost-free policy

measures to provide affordable housing, warnings generally fell on deaf ears.

However, by 2008, the housing market crash had transformed risk into reality. As the value of

mortgage assets Fannie and Freddie held plummeted and their share prices dropped from over

$60 in July 2007 to less than $10 just a year later, the government determined that the two GSEs

were likely to become insolvent and ultimately collapse. On September 7, 2008, facing the

prospect that Fannie and Freddie’s collapse would weaken housing and credit markets and

threaten macroeconomic stability, the government decided to temporarily placed the GSEs under

conservatorship. Although this measure may address immediate-term concerns, policymakers

must ultimately chart a future path for Fannie and Freddie. What is the appropriate structure for

Fannie and Freddie in the future? How should that structure be instituted?

The Federal Reserve Bank of Cleveland commissioned this report to help answer these

questions. Based on quantitative data, empirical studies, econometric analyses, relevant

literature, and a case study, this report finds that Fannie and Freddie do not provide a continued

public value through their role in the housing market and could be feasibly privatized.

Findings GSE structure is inappropriate policy measure.

The kind of market imperfection that justified government intervention to create a secondary mortgage market no longer exists because the private sector alone can now serve this function. Fannie and Freddie are inappropriate also because they are not narrowly tailored to meet housing goals for targeted homebuyers. They are allowed to purchase and securitize loans far beyond the range that includes most low-income first-

1 King, A. (September 8, 2008). Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer. Washington

D.C.: CATO Institute.

3

time buyers. Further, GSEs are inappropriate means of intervention because two attributes essential to the soundness and safety of public companies are nonexistent in a GSE: primary concern for shareholder interests and conferring risks and rewards to investors only. As such, they lack important checks on risky decisions.

Fannie and Freddie provide limited public benefits.

The two housing GSEs claim that they provide affordable housing through lower mortgage rates and increase homeownership in the U.S. Nevertheless, analyses and econometric testing of quantitative data show that Fannie and Freddie have actually produced only limited public benefits. First, their impact on mortgage rates is not statistically significant. Second, reductions in mortgage rates are shown to translate into only small increases in homeownership rates generally and among targeted borrowers.

GSEs are not necessary to serve Fannie and Freddie’s public missions.

Private firms can serve the housing GSEs’ mission to expand homeownership through secondary mortgage market activities. Also, the market as a whole now finances a larger proportion of mortgages for targeted homebuyers than Fannie and Freddie. Indeed, much of the GSEs’ activities function only to boost the size of their retained portfolios, which have no bearing on their public missions.

Privatization of Fannie and Freddie is both optimal and feasible structural reform.

There are strong theoretical and policy arguments to privatize these GSEs, such as reducing their systemic risk and conferring to them essential attributes of safe and sound corporate decision-making. Moreover, the successful privatization of a similar GSE in the student loan market, Sallie Mae, highlights the benefits of privatizing and offers valuable lessons in charting a privatization course, such as the need to undo the effects of governmental sponsorship and the effectiveness of a holding company model in transitioning from GSE to private company. Historically, however, pragmatic challenges have undermined the normative case for privatization. These include political resistance due to effective lobbying and support networks and fear of increased mortgage rates on homeownership. Nevertheless, these historic obstacles can now be overcome because of recent political developments and the many ways to structure a privatization plan to effectively address such challenges. Lastly, compared to either nationalization or retaining them as GSEs but subject to size or regulatory restrictions, privatization is the best option. While a revised GSE structure may reduce systemic risk, it ignores GSEs’ other shortcomings due to their flawed structure, limited public value, and the limits of regulation. Inversely, while nationalization is more responsive to such shortcomings, it does not lower systemic risk. Only privatization addresses both sets of flaws.

This report finds a clear need to reform and privatize Fannie and Freddie. As GSEs, they are

inappropriate, minimally beneficial, and unnecessary means to serve their particular public

housing missions. Any long-term reform should thus remove their GSE status. Weighing various

alternatives, precedents, and key policy considerations, privatization is certainly the optimal

future path for Fannie and Freddie.

4

Recommendations

The U.S. Treasury Department should pursue reforms for Fannie and Freddie that will

successfully help them transition from GSEs to private companies without undermining either

immediate-term concerns or important housing goals. This report recommends that the Treasury

adopt a three-step approach:

Step 1: Short-Term Focus on Mortgage Market Stability

In the current economic environment, private firms are unlikely to adequately serve the secondary mortgage market as would be expected under better conditions. Also, Fannie and Freddie are too financially unstable right now to profitably operate as private firms. Accordingly, the Treasury should continue supporting the FHFA’s role as Fannie and Freddie conservator in the short-term and help finance the companies’ secondary market activities. During this period, the Federal Reserve Board should communicate with the Treasury Department and FHFA and develop a mutually agreeable privatization plan to propose to Congress. There is no set time frame for this period.

Step 2: Privatize Fannie and Freddie Using Holding Company Model

After the conservatorship period, the housing GSEs should be privatized according to a plan similar to Sallie Mae’s holding company model. As such, Fannie and Freddie should be owned by two different and new holding companies as their GSE subsidiaries. Those two holding companies should also each own a set of numerous other subsidiaries that initially can engage only in non-GSE activities until GSE subsidiaries all liquidate. These non-GSE subsidiaries will eventually represent a privatized form for Fannie and Freddie. Notably, unlike the Sallie model, the plan for Fannie and Freddie creates numerous non-GSE subsidiaries that will eventually form numerous private companies and restricts fund transfers from GSE to non-GSE subsidiaries.

Step 3: Pursue Affordable Housing Goals Through Other Measures

Compared to housing GSEs, there are more narrowly tailored, effective, and efficient policy measures to meet affordable housing goals without posing a systemic risk or contingent taxpayer liability. Although this report does not conduct a detailed evaluation of alternatives, options include down-payment or monthly payment assistance, expansion of other housing programs, a new agency whose sole function is as lender of last resort, or increased funding for nonprofit organizations and public-private partnerships.

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INTRODUCTION

As of September 7, 2008, Fannie Mae and Freddie Mac, government-sponsored enterprises

(GSE) with a critical role in the U.S. home mortgage market, have been government

conservatorships.2 Previously, akin to all GSEs, Fannie and Freddie were shareholder-owned

corporations with a public mission. However, in accordance with the Federal Housing Finance

Regulatory Reform Act of 2008, enacted July 30, 2008, the Federal Housing Finance Agency

(FHFA), the new housing GSE regulatory agency, is now the Conservator for Fannie and

Freddie.3 As Conservator, the FHFA has assumed the power of Fannie and Freddie’s Board of

Directors and management, with full control of the assets and operations of the two GSEs.4 As

such, GSEs’ CEOs have been replaced and shareholders’ voting rights are suspended until the

termination of the conservatorship period.

Government-sponsored enterprises (GSE) are financial services corporations created by the US

Congress to increase the availability and lower the cost of credit to targeted borrowing sectors.

Sectors in which GSEs have operated include agriculture, home finance, and education. The two

large housing government-sponsored enterprises (GSE) in the United States are Fannie Mae and

Freddie Mac.5 They were created to offer affordable housing to the US community where credit

markets were imperfect by facilitating the stability and liquidity of the secondary residential

mortgage market. For example, in the early 20th century, many potential rural homeowners did

not have ready access to bank loans due to their geographic isolation. Housing GSEs, in

response, would help extend mortgages to rural residents when the mortgage market itself was

insufficient to meet this need.

2 Mark Jickling, "Fannie Mae and Freddie Mac in Conservatorship," CRS Report for Congress, September 15, 2008.

(According to FHFA, a conservatorship is “the legal process in which a person or entity is appointed to establish

control and oversight of a Company to put it in a sound and solvent condition.”) 3 Arnold King, Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer, Briefing Papers (Washington D.C.:

CATO Institute, September 8, 2008). 4 Id. 5 This report will not discuss another home finance GSE, Federal Home Loan Banks (FHLB) because their function

is substantially different from that of Fannie and Freddie. Specifically, the FHLB provide advances (i.e. loans) to

member-institutions, such as commercial banks or thrift institutions. The FHLB rely on the mortgages member-

institutions originate as collateral to continue extending more mortgage loans. Unlike Fannie and Freddie, the FHLB

are not allowed to guarantee mortgage-backed securities or to hold mortgages in their portfolios.

6

Credit markets today are much less likely to have market imperfections due to the evolution of

highly efficient financial markets. Nonetheless, Fannie Mae and Freddie Mac continue to exist

and own a large and growing share of the secondary mortgage market. Their size and

concentration has proven to be a huge risk to US economic health and stability, as evidenced by

the subprime mortgage industry’s role in the 2008 economic crisis.

According to FHFA, the purpose of placing Fannie and Freddie into conservatorship is to

preserve and conserve their assets and put them in a sound and solvent condition.6 In doing so,

the FHFA hopes to respond to immediate-term concerns, reasoning that conservatorship would

help restore confidence in Fannie and Freddie, improve the GSEs ability to serve their missions,

mitigate the systemic risk partly responsible for the instability in the current market, and help

provide mortgage financing during a crisis in credit markets.7 Although conservatorship of

Fannie and Freddie may respond to such immediate-term concerns, the government must

eventually implement a long-term plan for the two GSEs. The conservatorship period is

temporary and once its purpose has been adequately met, Congress may redefine the mission and

redesign the structure of Fannie and Freddie. Accordingly, this report focuses on answering the

key questions: What should be done with Fannie and Freddie going forward? How?

The next section details the research methodology used to address these questions. Then, in the

Background and Context section, Fannie and Freddie’s features, mission, growth, risks, financial

troubles, and present conservatorship status are discussed. After providing a contextual

framework for Fannie and Freddie, the Findings section analyzes the quantitative data and

qualitative arguments, drawn from the research methodology discussed earlier, to support four

findings regarding the need to remove Fannie and Freddie’s GSE status and privatize them.

Finally, the Recommendations section lists the three major steps to privatize Fannie and Freddie.

6 Arnold King, Freddie Mac and Fannie Mae: An Exit Strategy for the Taxpayer, Briefing Papers (Washington D.C.:

CATO Institute, September 8, 2008). 7 Id.

7

METHODOLOGY

In deciding the most appropriate structure and role for Fannie and Freddie after the

conservatorship period, some secondary questions were addressed: What were the implications

or consequences of the GSE status of Fannie and Freddie? Are Freddie and Fannie appropriate or

necessary to accomplish their missions? Would private markets better serve these missions? Is

privatization possible? Answering these questions requires a research design that includes

collection and analysis of both quantitative and qualitative data.

Quantitative analyses could be divided into three categories:

1. Empirical Studies of Macroeconomic Effects of Fannie and Freddie GSE Structure: Both before and after placing Fannie and Freddie in conservatorship, many government agency and think tank studies have evaluated the macroeconomic risks and effects of the two companies due to their structure as GSEs. These studies demonstrates the context in which the government decided to place the GSEs in conservatorship and the reasons for broad consent both in and out of government circles to restructure Fannie and Freddie.

2. Empirical Studies of Social Impact of Fannie and Freddie: Numerous government agencies, think tanks, and academicians have published studies that assess and value Fannie and Freddie in different ways. These studies were part of the evaluation of the two GSEs’ impact on mortgage rates and homeownership, social benefits and costs, risks, and public value relative to alternative policy measures. Their statistical methods included regression discontinuity analysis, vector autoregression, and underwriting simulations.

3. Econometric Analyses: Econometric tests were conducted to evaluate the impact of Fannie and Freddie on mortgage rates and homeownership in targeted groups. The tests included a t-test for statistical significance and a regression discontinuity analysis. These tests were based on current and historic data on and trends in Fannie and Freddie, homeownership rates, mortgage rates, and mortgage rate spreads.

While quantitative data and analyses was valuable in measuring the impact and effectiveness of

Fannie and Freddie, qualitative research and analysis would be required to determine the

appropriateness of the GSE structure as a policy mechanism, learn from previous attempts to

reform GSEs, and evaluate various policy responses. As such, qualitative research included:

1. Literature Review: Research of publications from a range of sources was valuable to obtain qualitative information about Fannie and Freddie’s structure, original intent, institutional growth, mission expansion, macroeconomic role, conservatorship, and options for structural

8

change. The literature review included legislative documents, agency publications, statements, and press releases, academic and think tank publications, media articles, and transcripts of interviews with government officials.

2. Case Study: In light of significant similarities between Sallie Mae and Freddie and Fannie, the successful privatization of Sallie Mae was used as a case study with potentially valuable lessons for charting Fannie and Freddie’s future. Despite accounting for the key differences between Fannie and Freddie and Sallie Mae, this case study would help identify requirements of successful privatization and offer lessons in privatizing Fannie and Freddie.

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BACKGROUND & CONTEXT

Creation: Original Mission & Operational Features of Fannie and Freddie

In the 1930s, housing markets were in turmoil. The wave of bank defaults during the Great

Depression left a large gap in the mortgage lending industry. A typical mortgage required about a

50 percent down payment and a balloon principal payment a few years later. Limitations in

financial and communication technology hindered the transfer of funds between regions of the

country, which was often required to finance homeownership. Congress responded by creating a

series of entities and programs that fostered the development of long-term, amortizing mortgages

and facilitated the movement of capital, including the creation of a government housing agency,

Fannie Mae, in 1938.8 Under budgetary pressures during the Johnson administration, however, in

1968 Congress spun off Fannie Mae to private investors and transformed it into a GSE in 1968.

As a GSE owned by shareholders just like public companies, Congress effectively removed the

Fannie’s expenses from the federal budget. Then in 1970, to prevent monopolistic behavior and

to overcome regulatory impediments in providing mortgage financing in California, Congress

created a new government housing agency, Freddie Mac. In 1989, Freddie was sold to private

investors and became a housing GSE just like Fannie in 1968.

Mission

Under their charters, the mission of Fannie and Freddie is to facilitate the steady flow of low-cost

mortgage funds. Specifically, Freddie Mac’s website states as its goal “to provide liquidity,

stability, and affordability” to the housing market. Similarly, Fannie’s website states that the

company seeks to “expand affordable housing and bring global capital to local communities to

serve the US housing market.” Further, through new legislation in 1992, Congress formally

expanded Fannie and Freddie’s mission to promote homeownership for low-income and minority

households and neighborhoods.9 Thus, Federal Reserve Chairman Ben Bernanke concludes

8 Office of Management and Budget, Budget of the U.S. Government: Fiscal Year 2009 (Washington D.C., 2009),

77. 9 Neil Bhutta, Regression Discontinuity Estimates of the Effects of the GSE Act of 1992, Federal Reserve Board

(Washington D.C., 2009). 1992 Federal Housing Enterprise Financial Safety and Soundness Act (hereinafter “GSE

Act of 1992”)

10

“Congress chartered these two companies with the goal of expanding the amount of capital

available to the residential mortgage market, thereby promoting homeownership, particularly

among low- and middle-income households.”10 Thus, Fannie and Freddie were created to meet

three related goals: (1) to expand homeownership (2) particularly to low- and middle-income

households (3) with affordable housing.

Operational Features

Among the numerous forms available to address a market imperfection through government

intervention, the GSE structure is a popular mechanism for Congress because its costs are hidden

“off-budget”.11 Indeed, even though Fannie Mae had increased liquidity in the market as a

government agency, the Johnson restructured it as a GSE precisely in response to budgetary

pressures during the late 1960s. Thus, by structuring them as private companies with a federally-

chartered public mission, Congress used the GSE structure “as a back-door method to increase

spending on housing without having to go through the appropriations process.”12

Congress envisioned that the specific method by which Fannie and Freddie would serve their

public mission would be to purchase and guarantee mortgages through the secondary mortgage

market. While institutions in the primary mortgage market were wholly responsible for

originating and servicing mortgages, the secondary mortgage allowed the purchase and sale of

mortgage loans and servicing rights between mortgage originators, mortgage aggregators

(securitizers), and investors. The secondary mortgage market could thus free capital and provide

liquidity to mortgage originators so that they, in turn, can extend more home loans.

How could Fannie and Freddie free capital and inject liquidity into the mortgage market? A

prospective homeowner would obtain a mortgage in the primary mortgage market from an

institution that originates and services mortgages in this market, such as a mortgage company or

a commercial bank. These primary market institutions could then sell mortgages (or mortgage-

backed securities (MBS) that have been issued back to them) to secondary market institutions

like Fannie and Freddie, who finance their purchases through debt issues. The sale proceeds from

10 Ben Bernanke, "GSE Portfolios, Systemic Risk, and Affordable Housing," Independent Community Bankers of

America's Annual Convention (Honolulu, March 6, 2007). 11 Vern McKinley, "The Mounting Case for Privatizing Fannie Mae and Freddie Mac," CATO Policy Analysis

(1997), 11. 12 Ibid.

11

this sale to a secondary mortgage market institution then frees up the funds initially used to

originate those mortgages so that the originators can use those funds to originate new mortgages.

Thus, secondary market institutions like Fannie and Freddie ensure that mortgage originators in

the primary market continue to have funds for new mortgages.

Although Fannie and Freddie were assigned a public mission, as public companies whose shares

were traded on the New York Stock Exchange, they were also profit-driven companies with

shareholders. Fannie and Freddie generate profit in two ways:

1. Guarantee Fee Income – Fannie and Freddie retain a certain percentage of each mortgage payment for each mortgage they have guaranteed a timely principal and interest payment of to a MBS holder. Basically, the housing GSEs would hope to collect more in guarantee fee income than they were obligated to pay to MBS holders in the event of borrower default. The MBS the public held have averaged about one-quarter of the US mortgage market and totaled $3.5 trillion as of November 30, 2007.13

2. Retained Portfolios – Fannie and Freddie have huge retained portfolios of mortgages and MBSs. They invest heavily in their own, and each other’s, securities. When GSEs retain securities instead of selling them, they earn a financing profit due to the spread between the retained security yield and interest rate on issued debt.14 Combined mortgage assets of Fannie and Freddie retained portfolios were valued at $1.5 trillion as of June 30, 2008.15

Growth: Rapid Expansion of Fannie & Freddie

Since their creation, Fannie and Freddie have steadily grown at a rapid pace and now own a large

percentage of the secondary housing market. According to then Treasury Secretary Robert K.

Steel, at 2006 year end the combined mortgage portfolios of Fannie and Freddie was $1.4

trillion.16 On average, the combined size of Fannie and Freddie has more than doubled every five

years since 1968.17

13 Office of Management and Budget, Budget of the U.S. Government: Fiscal Year 2009 (Washington D.C., 2009),

78. 14 Wayne Passmore, Shane M. Sherlund Andreas Lehnert, GSEs, Mortgage Rates, and Secondary Market Activities, Federal Reserve Board (Washington D.C., 2006), 3. 15 Jickling (2008) 1. 16 Barry Nielson, Fannie Mae and Freddie Mac, Boon or Boom. 17 Kevin R. Kosar, Government-Sponsored Enterprises (GSEs): An Institutional Overview, CRS Report to Congress

(Washington D.C.: Congressional Research Service, April 23, 2007), 5.

12

Source: Office of Federal Housing Enterprise Oversight, Report to Congress (2008)

Cause of Rapid Growth: Implicit Guarantee

Fannie and Freddie have been able to grow rapidly and own such a large share of the secondary

mortgage market primarily due to an implicit guarantee by the government that if these GSEs are

unable to meet their obligations in response to major financial troubles, the US government

would pay what the GSEs owe. Although the U.S. government never explicitly guaranteed

Fannie and Freddie’s MBS-based obligations, the market believed that such a guarantee existed.

Indeed, in its letter to the Office of the Comptroller of Currency, even Fannie Mae acknowledged

the existence of this implicit federal guarantee by reasoning that the GSE’s domestic obligations

“typically receive no rating on an issue-by-issue basis, because investors and rating agencies

view the implied government backing of Fannie Mae as sufficient indication of the quality of

Fannie Mae obligations.”18

18 Ibid.

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

3,500,000

4,000,000

Dollars(inmillions)

Years(1971­2007)

CombinedBalanceSheetsofFannie&Freddie

(1971­2007)TotalAssets($)

TotalRetainedMortgagePortfolio($)

DebtOutstanding($)

ShareholderEquity($)

TotalMortgageBackedSecuritiesOutstanding($)

13

The implicit guarantee of federal backing for Fannie and Freddie obligations resulted from the

many valuable benefits Congress conferred upon the GSEs as quasi-governmental entities.19

These express, legislative benefits included exemption from state and local taxes, availability of

a $2.25 billion line of credit from the Treasury, exemption from SEC registration and reporting

requirements, and the designation of GSE securities as “government securities” for purposes of

the SEC Act of 1934. By treating the GSEs almost as favorably as government agencies, these

legislative benefits gave Fannie and Freddie the appearance of fully government guaranteed

entities whose obligations were backed by the government in the event of default.

How does an implicit federal guarantee allow Fannie and Freddie to grow too much? The market

perception that GSE obligations are backed by the federal government permits GSEs to borrow

at much less cost than other companies.20 Indeed, the implicit guarantee has allowed these GSEs

to borrow in capital markets at an interest rate only slightly higher than that paid by the US

Treasury and less than the rate paid by other private companies in mortgage markets.21 One study

estimates that GSEs borrow at spreads of one-fourth a percentage point above the US Treasury’s

rate, despite lacking the full faith and credit of the federal government that US Treasuries

guarantee.22 With such a preferential interest rate, GSEs face strong incentives to purchase

assets, such as MBS, that promise returns significantly larger than the interest rates they pay. As

such, they seek to maximize their portfolio growth to yield profits on an increasingly large scale.

19 Vern McKinley, "The Mounting Case for Privatizing Fannie Mae and Freddie Mac," CATO Policy Analysis

(1997), 2. 20 Thomas H. Stanton, Government-Sponsored Enterprises: Mercantalist Companies in the Modern World (Washington D.C.: The AEI Press, 2002), 37. 21 Ben Bernanke, "GSE Portfolios, Systemic Risk, and Affordable Housing," Independent Community Bankers of

America's Annual Convention (Honolulu, March 6, 2007). 22 Thomas H. Stanton, Government-Sponsored Enterprises: Mercantalist Companies in the Modern World

(Washington D.C.: The AEI Press, 2002), 37.

14

By lowering the cost of borrowing and allowing Fannie and Freddie to earn profits greater than

competitors in the secondary mortgage market, the implicit guarantee confers a federal subsidy

to the GSEs. Specifically, the value of the subsidy in a given year equals the value of interest

savings on new securities originated that year.23 The Congressional Budget Office (CBO) defines

this value of interest savings on newly originated securities as “the spread between the rates on

the enterprises’ securities and those originated by financial firms with comparable ratings.”24

CBO estimates that this subsidy is 41 basis points on debt and 3 basis points on MBS.

The federal subsidy to Fannie and Freddie in the form of lower interest rates is also reflected by

the amount of the housing GSEs’ total subsidy. According to CBO’s 2004 update to an earlier

study estimating the total subsidies to housing GSEs, the federal government’s subsidy to the

housing GSEs amounted to roughly $19.6 billion in 2003 (the last year for which the CBO

published estimates of subsidy to housing GSEs.)25 Notably, this base case estimate is based on

the assumption that mortgages purchased by GSEs and the MBS they issue to finance them have

an average life of seven years and will not be reissued upon maturity. However, consistent year-

over-year increases in the GSEs’ outstanding securities and assets suggest that this assumption is

inaccurate. Instead, it is more likely that future growth in outstanding debt and MBS will be

sustained and securities will be reissued when they mature. Accordingly, the federal subsidy

would more than double the base case estimate to $41.7 billion.26

Risks of Fannie & Freddie’s GSE Structure

Critics of housing GSEs worry about their systemic risk to the U.S. economy and financial risk

to taxpayers. They argue that by facilitating the growth and huge market share of Fannie and

Freddie, this implicit guarantee results in a major systemic risk and contingent liability for

taxpayers if the GSEs faced major financial troubles. Systemic risk is “the risk that disruptions

occurring in one firm or financial market may spread to other parts of the financial system, with

possibly serious implications for the performance of the broader economy.”27

23 Congressional Budget Office, "Updated Estimates of the Subsidies to the Housing GSEs," (2004), 1. 24 Ibid. 25 Ibid 10. The CBO study data includes three housing GSEs – Fannie, Freddie, and the FHLB. This report has

adjusted the CBO study’s data to exclude FHLB. 26 Ibid 8. 27 Ben Bernanke, "GSE Portfolios, Systemic Risk, and Affordable Housing," Independent Community Bankers of

America's Annual Convention (Honolulu, March 6, 2007).

15

The debt and MBSs issued by Fannie and Freddie are held by both US and foreign banks and

financial institutions. As of March 2007, the two companies had $5.2 trillion of debt and MBS

obligations, more than publicly held debt of the US government totaling $4.9 trillion.28 At the

end of 2007, non-U.S. investors held $479 trillion of the $7.397 trillion in debt held by

government agencies and GSEs combined, U.S. commercial banks held $929 billion, life

insurance companies $388 billion, state and local government retirement funds $317 billion,

mutual funds $566 billion, asset-backed issuers $378 billion, and the GSEs themselves $710

billion.29 According to a 2004 Federal Deposit Insurance Corporation report, more than 11% of

total assets and 150% of Tier 1 capital of commercial banks and savings associations were

holdings of GSE-related securities.30 On March 6, 2007, Federal Reserve Bank Chairman Ben

Bernanke stressed the risk Fannie and Freddie pose to macroeconomic stability: “The activities

of the GSEs are not confined to debt markets; because the GSEs engage in extensive hedging

activities, these companies are among the most active users of derivative instruments. Thus, by

any measure, the GSEs have a significant presence in the US financial markets.”31

28 Ibid. 29 N. Eric Weiss, Fannie Mae's and Freddie Mac's Financial Problems, CRS Report for Congress (Washington D.C.: Congressional Research Service, September 12, 2008), 5. 30 Peter J. Wallison, Fannie and Freddie by Twilight (Washington D.C.: American Enterprise Institute for Public

Policy Research, August 2008), 2. 31 Ben Bernanke, "GSE Portfolios, Systemic Risk, and Affordable Housing," Independent Community Bankers of

America's Annual Convention (Honolulu, March 6, 2007).

16

Further, unlike other private firms, the risk these GSEs pose cannot be expected to be mitigated

through market discipline. Typically, market disciplines curbs excessive risk-taking because the

creditors of a firm have strong incentives to monitor risky activities. If creditors believe that a

firm is taking on too much risk, they will respond by either reducing their exposure through

removing their invested capital in the firm or require greater compensation in lieu of the

additional risk. However, market discipline by creditors does not restrain risky behavior by

Fannie and Freddie because creditors believe that these two GSEs are backed by the US

government’s “implicit guarantee.”32

Current Changes: Financial Troubles & Government Conservatorship

Financial Troubles

In July 2007, both Fannie and Freddie shares traded above $60. Between July 8 and 15, 2008,

however, Fannie and Freddie’s shares fell from $17.51 and $13.46 to $7.02 and $5.26,

respectively.33 Share prices fell because the credit risk of Fannie and Freddie materialized. Credit

risk indicates the impact borrower defaults will have on the lender. When home prices are rising,

there is less risk of mortgage default. In a February 6, 2004 speech, the chairman of Fannie Mae,

Franklin Raines, argued that although Fannie is highly leveraged, it is not a significant risk to the

government or taxpayers because it invests in home mortgages, one of the safest investments in

the world.”34 However, since US home prices peaked in July 2006, they have declined 19.3% on

a cumulative basis and are currently back to the lowest price level since May 2004.35

32 Douglas Holtz-Eakin, "Aligning the Costs and Benefits of the Housing Government-Sponsored Enterprises," CBO Testimony (Washington D.C.: Committee on Banking, Housing, and Urban Affairs, April 21, 2005), 8. 33 Jickling (2008) 2. 34 Thomas H. Stanton, Bert Ely Peter J. Wallison, Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan

Banks: Why and How, American Enterprise Institute (Washington D.C.: The AEI Press, 2004), 4. 35 First American Core Logic, Media Alert: February 18, 2009, available at: http://www.loanperformance.com/

17

Source: Fannie Mae

With declining home prices, homeowners began defaulting on mortgages in unexpected

numbers. In 2004, William Poole, President of the Federal Reserve Bank of St. Louis, expressed

his confidence in Fannie and Freddie’s credit risk mitigation measures, not considering home

prices may drop nationwide: “Even though default rates on mortgages in the United States are

low, in recent years less than 1 percent, they are not zero and vary considerably across regions.

Credit risk on mortgages can be handled, as in fact Fannie and Freddie do very effectively … In

assessing credit risk, it is important not to focus just on national average conditions. For

example, although average house prices in the United States have not declined year to year since

the Great Depression, prices have declined in particular significant markets.”36

Falling home prices may not have triggered such huge spikes in default rates had it not been for

Fannie and Freddie’s role in greatly increasing subprime and Alt-A mortgages.37 By 2007,

Fannie and Freddie were required to show that 55% of their total mortgage purchases were low-

36 William Poole, "GSE Risks," Speech to St. Louis Society of Financial Analysts (Federal Reserve Bank of St.

Louis, January 13, 2005). 37 Peter J. Wallison, Cause and Effect: Government Policies and the Financial Crisis, American Enterprise Institute:

Financial Services Outlook (November 2008) (stating “There is no universally accepted definition of either

subprime or Alt-A loans, except that neither of them is considered a prime loan (fifteen- or thirty-year amortization,

fixed interest rate, good credit history) and both thus represent enhanced risk. The Federal Reserve Bank of New

York defines a subprime loan as one made to a borrower with blemished credit or who provides only limited

documentation. The federal bank regulators define a loan to a borrower with less than a 660 FICO score as subprime. Alt-A loans generally have a higher balance than subprime and one or more elements of added risk, such

as a high loan-to-value ratio (often as a result of a piggyback second mortgage), interest-only payments, little or no

income documentation, and the borrower as an investor rather than a homeowner. The term "subprime,"

accordingly, generally refers to the financial capabilities of the borrower, while Alt-A loans generally refer to the

quality of the loan terms.” p. 5)

18

and middle-income loans, of which 38% were from underserved areas. To meet these goals,

Fannie and Freddie had to purchase subprime and Alt-A loans from which they previously shied

away.38 And although the national mortgage default rate on prime mortgage remained around

1%, the default rate for subprime mortgage holders increased from around 6% in 2005 to almost

14% in 2007. Thus, in light of the $1.6 trillion in subprime and Alt-A mortgages Fannie and

Freddie hold or guarantee together, the increasing defaults on these mortgages had disastrous

effects on the two GSEs’ net assets and MBS obligations.

Early Payment Defaults on Subprime Loans

Following the rapid drop in the value of Fannie and Freddie’s mortgage assets and their share

prices, the GSEs were likely to become unable to meet their debt obligations and eventually fail.

With the rise of mortgage defaults, by 2007 Fannie and Freddie began experiencing huge losses

on their retained portfolios. Data in Table 1 demonstrates the rapid and significant loss in

profitability by the GSEs. While in 2006, Fannie and Freddie’s profits were $4.059 billion and

$2.327 billion, respectively, by 2007 Fannie’s losses were larger than $2 billion and Freddie’s

surpassed $3 billion. Failure, in turn, could trigger major disruptions in global financial markets,

greater costs and difficulty in obtaining home mortgages, and negative economic repercussions.39

38 Peter J. Wallison, Cause and Effect: Government Policies and the Financial Crisis (Washington D.C.: American

Enterprise Institute for Public Policy Research, November 2008), 5. 39 Jickling (2008) 4.

19

Government Conservatorship

As of 2008, Fannie and Freddie were unable to access capital markets without governmental

financial assistance. Without access to new capital, the GSEs would have to stop new business

and shed their assets in a weak market.40 This would, in turn, have disastrous implications for

both the mortgage markets and the GSEs since mortgage rates would continue to increase,

Fannie and Freddie shares would then drop in price, and credit losses would have increased.

In 2008, FHFA concluded that the two GSEs would be insolvent and government intervention

was necessary. FHFA Director James B. Lockhart decided that “in order to restore the balance

between safety and soundness and mission, FHFA placed Fannie Mae and Freddie Mac into

conservatorship. That is a statutory process designed to stabilize a troubled institution with the

objective of maintaining normal business operations and restoring its safety and soundness.”41

Further, the FHFA’s determination that Fannie and Freddie needed to be placed in

conservatorship was supported by both the Chairman of the Board of Governors of the Federal

Reserve System, Ben Bernanke,42 and Secretary of the Treasury, Henry Paulson.43

A central goal of the conservatorship plan is to keep the financial operations and conditions of

the GSEs solvent and sustainable by providing government financing to Fannie and Freddie.

Under the September 7, 2008 conservatorship plan, several government agencies extend various

forms of capital investments totaling $100 billion in each GSE. These include Federal Reserve

purchases of GSE debt and GSE-held mortgage backed securities and Treasury Department

purchases of GSE stock and MBS. The Treasury’s commitments end on December 31, 2009,

when the GSEs must begin reducing the size of their portfolios by 10% annually. Moreover, on

February 18, 2009, under the new Obama Administration, the federal government doubled its

financial backing of Fannie and Freddie to $200 billion in each. 44

40 James B. Lockhart III, "Statement of The Honorable James B. Lockhart III Before the House Committee on

Financial Services on the Appointment of FHFA as Conservator for Fannie Mae and Freddie Mac" (Washington

D.C., September 25, 2008), 2, 5. 41 Ibid 6. 42 Ben Bernanke, "Statement by Federal Reserve Board Chairman Ben Bernanke," Press Release, September 7, 2008. 43 Henry M. Paulson, Statement by Secretary Henry M. Paulson on Treasury and Federal Housing Finance Agency

Action to Protect Financial Markets and Taxpayers (Washington D.C.: U.S. Department of the Treasury, September

7, 2008). 44 Jickling (2008) 3-5.

20

Through its infusions of capital into Fannie and Freddie, the federal government has made

explicit the formerly implicit federal guarantee to meet the housing GSEs’ obligations. The

government’s intervention in the companies as conservator aims to reduce the uncertainty about

home values and mortgage-related assets and create conditions that allow markets to return to

normalcy.45 However, as of March 5, 2009, the shares of each company traded at $0.37.

Future: Structural Reform of Fannie and Freddie

Although the government placed Fannie and Freddie in conservatorship to address immediate-

term concerns about poor credit markets, housing markets, and macroeconomic stability, it must

ultimate decide Fannie and Freddie’s long-term fate. The Treasury commitment to make open

market purchases of GSE MBS and to create a Government Sponsored Enterprise Credit Facility

in case the GSEs have difficulty borrowing money ends on December 31, 2009.46 Thus the

Treasury’s commitments will “promote stability in the secondary mortgage market and lower the

cost of funding” by allowing the housing GSEs to modestly increase their MBS portfolios

through December 31, 2009.47After that date, focus will shift to address Fannie and Freddie’s

systemic risk by requiring their portfolios to be gradually reduced by 10% per year and

eventually stabilize at a lower, less risky size.

45 Ibid. 46 N. Eric Weiss, Fannie Mae's and Freddie Mac's Financial Problems, CRS Report for Congress (Washington D.C.:

Congressional Research Service, September 12, 2008), 3. 47 Henry M. Paulson, Statement by Secretary Henry M. Paulson on Treasury and Federal Housing Finance Agency

Action to Protect Financial Markets and Taxpayers (Washington D.C.: U.S. Department of the Treasury, September

7, 2008).

0

20

40

60

80

SharePrice($)

Dates(June2006­March2009)

FannieMae&FreddieMac:SharePrice

FreddieMac

FannieMae

21

In addition to the termination of Treasury commitments, the conservatorship of Fannie and

Freddie is only temporary and will end when the FHFA Director concludes that the safety and

soundness of the GSEs has been restored.48 Following an FHFA finding that the conservatorship

has achieved its mission, the federal government must determine the future of the two housing

GSEs. Treasury Secretary Paulson stresses that “Policymakers must view this next period as a

‘time out’ where we have stabilized the GSEs while we decide their future role and structure …

We will make a grave error if we don’t use this time out to permanently address the structural

issues presented by the GSEs.”49 Thus, the government must answer: What is the appropriate

structure for Fannie and Freddie in the future?

48 Federal Housing Finance Agency, Questions and Answers on Conservatorship, Fact Sheet (Washington D.C.,

2008). 49 Paulson.

22

FINDINGS

This report discusses four key findings that support the recommended future course and long-

term structural reforms of Fannie and Freddie:

GSE structure is not an appropriate mechanism to pursue Fannie and Freddie’s missions

Fannie and Freddie provide limited public benefits under their GSE structure

Fannie and Freddie are no longer necessary to operate as GSEs to serve their public missions

Privatization is an optimal and feasible long-term option for Fannie and Freddie

GSE Structure is Inappropriate Policy Mechanism

No Inevitable Market Imperfection

Government interventions in markets are appropriate and justified if they are necessary and

narrowly-tailored to correct a market imperfection. A market is imperfect if private firms

produce less of a good or service than socially optimal.50 As discussed earlier, such an

imperfection clearly existed when Fannie and Freddie first became GSEs because of illiquidity in

the mortgage markets, nationwide credit shortages, market instability, regional credit imbalances

and differences in interest rates, difficulties in assessing the credit quality of mortgages, and

foregone positive externalities of increased homeownership.51 Government intervened by using

new agencies to create a secondary mortgage market. Since there was not enough liquidity in the

mortgage markets to allow mortgage originators to meet the demand for home loans, potential

borrowers were either required to offer large sums in down payments or could not obtain a loan

at all. Ultimately, the combination of illiquid mortgage markets, costly down payment

requirements, and high mortgage rates had a negative impact on homeownership rates. Certainly,

a secondary mortgage market where mortgages from originators are bought and securitized

would address the illiquidity problem in mortgage markets by freeing capital for originators to

underwrite new home loans. Before Fannie’s creation in 1938, however, such a secondary

50 Lawrence J. White, "On Truly Privatizing Fannie Mae and Freddie Mac: Why It's Important and How to Do It,"

Fixing the Housing Finance System (Wharton School, University of Pennsylvania, 2005), 14. 51 McKinley (1997) 2.

23

mortgage market did not exist. As such, Congress may well have been justified to intervene and

create a secondary mortgage market.

The case for government intervention in the mortgage markets to correct a market imperfection –

to create a secondary mortgage market – is much less obvious today.52 As quantitative data and

qualitative analysis shows53, commercial banks now have the technology and expertise to

participate in a secondary mortgage market. Indeed, despite no government intervention, the

private sector has created a robust and growing secondary market for automobile loans.54 This

purely privately created secondary market has experienced significant growth, with securitized

automobile loans outstanding increasing from about $18 billion in 1989 to $44 billion in 1995.

As such, the automobile securitization sector epitomizes the innovation in secondary markets

today and the ability that the private sector can be trusted to create and operate an effective

secondary market. Due to the private sector’s ability to correct an historic market imperfection,

government intervention in the mortgage markets through Fannie and Freddie is unjustified and

inappropriate.

GSE Structure is Not Narrowly-Tailored

Further, the use of Fannie and Freddie to expand homeownership by targeted groups is a broad-

based housing policy measure that increases housing consumption and construction throughout

the income and social spectrum and not just among targeted homebuyers.55 For instance, the

median home price in 2008 was about $210,000, and an 80% mortgage on that price would have

been $168,000. Nevertheless, the conforming loans limit for Fannie and Freddie that year was

$417,000, more than twice the 80% mortgage on a median-priced home. The high ceiling for

conforming loans allow Fannie and Freddie to buy home mortgage loans that are far beyond the

range that includes most low- or moderate-income first-time buyers.

52 This analysis only considers Fannie and Freddie mission to expand homeownership broadly through their secondary mortgage market activities and not their mission under the GSE Act of 1992. 53 Refer to page 34-35. 54 McKinley (1997) 8. 55 Lawrence White, Fannie Mae, Freddie Mac, and Housing Finance: Why True Privatization Is Good Public Policy,

Draft, CATO Foundation (Washington D.C., 2004), 11.

24

GSE Structure Results in Companies Lacking Essential Attributes of Corporate Structure

Even if some market imperfection or social need today justified government intervention in

mortgage markets, GSEs are not the appropriate form of intervention because they are supposed

to be public companies yet lack attributes that are essential to the soundness and safety of public

companies: primary concern for shareholder interests and conferring both risks and rewards to

investors. Without these essential elements of the corporate form, managers at Fannie and

Freddie have engaged in excessively risky activities.

Some government officials have complained that minority, low-, and moderate-income

homeownership is too low in the U.S. Indeed, many congressmen complained that while Fannie

and Freddie may have lowered mortgage rates and generated huge gains for their shareholders,

the GSEs did not do enough to increase minority, middle-, and low-income homeownership. In

response, Congress passed the GSE Act of 1992 and mandated that Fannie and Freddie meet

certain housing goals for these targeted homebuyers. To meet these goals, however, the two

GSEs were burdened in balancing their investors’ private interests with a potentially conflicting

public mission. For example, while a private firm accountable only to shareholders would be

reluctant to purchase low-quality, high-risk subprime and Alt-A mortgages, Fannie and Freddie

increasingly bought such loans to meet their government-mandated goals. As recent history

proves, due to the size of their retained portfolios and the guarantees they sold to MBS

purchasers, an increase in the default rate for such risky mortgages results in huge losses for

Fannie and Freddie and a significant drop in their share prices.

A second example also illustrates the financial risks and costs of Fannie and Freddie’s dual

missions. While Congress limits permitted GSE activities through restrictions in a GSE charter to

protect against monopolistic effects in related industries and align GSE activities to a specific

public policy goal, such restrictions impair the ability of GSEs to protect against unexpected

risks and, consequently, threaten their financial stability. Charter limitations on permissible GSE

activities means that a GSE will become specialized in a designated market, unable to protect

itself against financial and political risks in that designated market through diversification.56 As

such, Fannie and Freddie activities in pursuit of their public mandate threaten their financial

56 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American

Enterprise Institute, May 9, 2007), 3.

25

soundness and stability. Thus, the impossible task of “serving two masters” whose interests are

not always aligned renders GSEs an inappropriate means of governmental intervention.

Further, GSEs are inappropriate as a public policy measure because, unlike most other public

companies, they privatize rewards but socialize their costs. Free market proponents trust

company managers to make sound and responsible decisions based on the notion that recipients

of company rewards also bear its risks. The transfer of both risk and reward to investors protects

against “moral hazard” and ensures that those investors will exercise “market discipline” and

curb excessively risky behavior by company managers.

While the large spread between their relatively low borrowing costs and the yield from

purchased mortgages and MBS due to an implicit guarantee have allowed Fannie and Freddie to

multiply in size and consistently produce huge gains for their private investors, that same

implicit guarantee has socialized the costs of Fannie and Freddie’s financial failure. As the

federal government’s rescue of the two GSEs in the last year demonstrates, taxpayers bear the

cost of rescuing the two companies when their risks materialize. Fannie and Freddie creditors,

confident in the federal government’s implicit guarantee to back the GSEs’ obligations, felt no

need to exercise “market discipline” on the two companies to protect their investment by

pressuring GSE managers to limit very risky behavior because the investors and creditors would

not have to bear the risk of any loss. Therefore, in addition to the dilemma in serving too many

masters, the GSE structure, with its corporate form, is an inappropriate policy measure because it

creates public companies whose decisions are guided mainly by investor interests despite

significant social risks and costs.

Fannie and Freddie Provide Limited Public Benefits

According to Fannie and Freddie, they provide a range of public benefits due to their GSE status.

For instance, Fannie claims the GSEs’ public benefits include affordable housing finance for

low- and middle-income and minority homebuyers and lower mortgage rates for all homebuyers.

Even if the GSEs actually conferred such public benefits, it is important to note that they are not

the source of these benefits, but rather a vehicle for conveying a subsidy to intended

26

beneficiaries – homebuyers.57 Beyond the public benefits they deliver, the case for maintaining

their GSE status must show that they are an efficient method of conferring such benefits.

Also, the exact public benefit, or positive externality, from lower home purchase costs is mainly

based on increasing homeownership rates, not just increasing home purchases. Homeowners are

more likely than renters to care about the upkeep of the home (with positive spillovers to

neighbors), to contribute to economic growth through spending on construction and home

furnishings, to refrain from criminal activity, and to be more community-minded.58 Thus, in

estimating Fannie and Freddie’s public benefit, the important issue is their impact on first-time

buyers and not on homebuyers generally.

Moreover, despite Fannie and Freddie’s contentions, substantial quantitative data and analyses

indicate that the two companies have actually generated only limited public benefits. As analyses

show, the impact of the two GSEs on mortgage rates is not statistically significant. Also, even if

they do measurably lower mortgage rates, such reductions are shown to translate into only small

increases in homeownership rates. Further, due to the operational features of Fannie and Freddie,

they fail to narrowly and effectively target low- and moderate-income and minority home buyers

and provide relatively little help to these groups. Thus, given Fannie and Freddie’s significant

systemic risk to the economy and mortgage markets due to their GSE structure, their limited

public benefits buttresses the case for restructuring Fannie and Freddie.

Benefit #1: Lower Mortgage Rates

Comparison of mortgage rates between conforming and jumbo mortgages (jumbo-conforming

loan spread) reveals that Fannie and Freddie have negligible effects on mortgage rates. Perhaps

the simplest measure of lowering mortgage rates by the GSEs, the jumbo-conforming loan

spread measures the mortgage rate reduction that consumers would receive by receiving a

conforming loan (a loan that qualifies for Fannie Mae and Freddie Mac mortgage programs)

versus a jumbo mortgage (a mortgage that is larger than the conforming loan limit).59 Under data

57 McKinley (1997) 21. 58 Lawrence J. White, "On Truly Privatizing Fannie Mae and Freddie Mac: Why It's Important and How to Do It,"

Fixing the Housing Finance System (Wharton School, University of Pennsylvania, 2005), 8. 59 Anthony Sanders, "The Role of the Government Sponsored Enterprises in the Mortgage Market," Before the

Committee on Banking, Housing, and Urban Affairs United States Senate, February 10, 2005, 5.

27

provided by the Federal Housing Finance Board60, the mean conforming loan interest rate for

years 1986-2006 was 7.67%, while the mean fixed-rate jumbo rate in the same period was

7.99%.61 (The graph below illustrates the small rate spread.) This study’s observed rate spread of

32 basis points falls within the 20 – 50 bps spread estimated by numerous studies.62

60 http://www.fhfb.gov/Default.aspx?Page=53 61 Mortgage rates for fixed-rate jumbo loans, rather than mortgage rates on all jumbo loans, was used in this analysis

to reflect the fact that many jumbo loans were subprime mortgages with adjustable rates initially set low. As such,

only fixed-rate jumbo mortgage rates should be considered as a more accurate indication of the rates for non-

conforming mortgages. 62 Sanders 6 (discussing various studies: “An early study by Hendershott and Shilling (1989) found that the jumbo –

conforming spread was approximately 30 basis points. Cotterman and Pearce (1996) found a jumbo – conforming

range of 25 to 40 basis points. Pearce (2000) found the jumbo-conforming estimate to be approximately 24 basis

points. Finally, Passmore, Sparks, and Ingpen (2002) generated the lowest estimate to the date by finding that the

jumbo – conforming spread was 20 basis points.”)

0.00

2.00

4.00

6.00

8.00

10.00

12.00

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

InterestRate(%)

MortgageInterestRates:Conformingvs.JumboFixed­RateLoans

Fixed‐RateJumboLoans

AllConformingLoans

28

T-Test for Statistical Significance of Fannie and Freddie’s Effect on Mortgage Rates

One method to evaluate the difference in mortgage rates between fixed jumbo and conforming

mortgages is to conduct a test for statistical significance. Significance is a statistical term that

means a difference or relationship exists given a certain level of confidence. In this analysis, a t-

test was used to determine if the higher mean rate for fixed-rate jumbo loans was statistically

higher than the mean rate for conforming loans during the period 1986-2006.63 Data used for this

t-test is in Table 2. The t-statistic from this test was 0.456. At the .001 confidence level, which is

regarded “highly significant”, the critical t-value for a sample size of 21 is 3.85. Since the value

of the t-statistic is lower than the critical t-value at the .001 confidence level, there is a 0.1%

chance that the gap between fixed-rate jumbo mortgage and conforming mortgage rates is

statistically significant. Therefore, this t-test suggests that GSEs have not had a significant effect

on mortgage rates.

Vector Autoregression Analysis of Fannie and Freddie’s Effect on Mortgage Rates

Moreover, a Federal Reserve Board study applied another statistical tool, a vector autoregression

(VAR) approach, to show that Fannie and Freddie’s secondary market activities - retained

portfolios and MBS issuances - do not significantly affect mortgage rates. VAR is used to

evaluate interrelationships between variables over time. In this case, VAR can be used to

determine whether the primary or secondary mortgage rate spread between conforming and

nonconforming loans increases over time as GSEs suddenly increase their secondary market

activities during the same period. In this 2006 Federal Reserve Board study, GSEs, Mortgage

Rates, and Secondary Market Activities, Andreas Lehnert, Wayne Passmore, and Shane

Sherlund, used a VAR approach on monthly data from March 1993 to December 2005 to reveal

that GSE portfolio purchases have no significant effects on either primary or secondary mortgage

rate spreads while MBS issuances and securitization has a small effect.64 Accordingly, the

authors of this study suggest that “curbing the growth of these portfolios might not increase

63 See Table 1 64 Wayne Passmore, Shane M. Sherlund Andreas Lehnert, GSEs, Mortgage Rates, and Secondary Market Activities,

Federal Reserve Board (Washington D.C., 2006), 3.

29

mortgage rates paid by new mortgage borrowers while mitigating the risks posed to taxpayers

and the financial system.”65

Benefit #2: Increased Homeownership

Even if Fannie and Freddie did lower mortgage rates significantly, their minimal reductions are

unlikely to cause a significant increase in homeownership by both the overall population of

homebuyers and homebuyers targeted by the GSE Act of 1992. The following analyses indicate

that it is wrong to assume that lower mortgage rates result in increased homeownership.

Underwriting Simulations on the Effect of Lower Mortgage Rates on Homeownership

Various underwriting simulations focused on quantifying the effect of a change in mortgage rates

on homeownership rates demonstrate the limited impact of Fannie and Freddie on

homeownership on both targeted groups and homebuyers generally.66 According to a Federal

Reserve Bank of Minneapolis study, a mortgage rate reduction of 200 bps will generally increase

the percentage of households that can buy a house by 50 bps.67 As discussed earlier, Fannie and

Freddie lower mortgage rates by 20-50 bps and, accordingly, will increase the homeownership

rate by much less than 50 bps. Most of the simulations found that the same 200 bps mortgage

rate shift would alter the percentage of black households that could buy a house by a mere 10

bps. The following table from this study shows the impact various levels of mortgage rates

reductions have on different groups’ homeownership rates according to two different studies.68

65 Ibid 6. 66 Ron Feldman, "Mortgage Rates, Homeownership Rates, and GSEs," 2001, 13. 67 Ibid 5. 68 Ibid 8.

30

Data & Qualitative Analysis of GSEs Impact on Homeownership by Targeted Groups

Data and analyses show that Fannie and Freddie negligibly increase minority, low-, and

moderate-income homeownership. HUD data for years 2004-2007 indicates that Fannie and

Freddie perform worse than private lenders in serving housing goals for targeted groups. For

example, although 41.8% of mortgages in 2007 were for low-income homebuyers, such

mortgages comprised only 36.2% of total mortgages purchased by Fannie and Freddie in 2007.69

Also, while mortgages for black and Hispanic homebuyers comprised 9.7% and 12.9% of the

mortgage market in 2007, they comprised only 7.2% and 11.1% of the two housing GSEs’

mortgage purchases that year, respectively. The following table from a Federal Reserve Bank of

Minneapolis study provides further support for Fannie and Freddie’s relatively small effect on

homeownership by first-time buyers and minorities and suggests that private lenders better serve

these groups: While black and Hispanic first time buyers comprised 11% and total first-time

buyers comprised 41% of all home purchases during 1997-1999, only 3% and 25% of GSE-

financed mortgages were received by blacks and Hispanics and first-time buyers, respectively.70

69 U. S. Department of Housing and Urban Development, Office of Policy Development and Research. Profiles of

GSE Mortgage Purchases in 2005-2007. Table 3a 70 Ibid 13.

31

As a result, a broad-based program like Fannie and Freddie largely benefits purchasers who

would have bought anyway to buy larger and higher-priced homes. Yet the positive externalities

of increased homeownership arise primarily from increasing the number of homeowners within

communities and nationwide and only minimally from the size or price of the home. Thus, a

GSE-based approach to meet housing goals for underrepresented groups is not a tightly focused

program “that would encourage low- and moderate-income households, who may be on the

margin between renting and owning, to become first-time home buyers.”71

Regression Discontinuity Estimate of the Effectiveness of the GSE Act of 1992

In a 2009 Federal Reserve Board study, Regression Discontinuity Estimates of the Effects of the

GSE Act of 1992, Neil Bhutta helps reveal Fannie and Freddie’s limited impact on increasing

low-income and minority homeownership by evaluating the causal relationship between the GSE

Act and increased homeownership by targeted homeowners. Under the 1992 Federal Housing

Enterprise Financial Safety and Soundness Act (or GSE Act), the housing GSEs are assigned

affordable housing goals specifying that a certain fraction of GSE mortgage purchases should be

of mortgages made to targeted households and neighborhoods. A purchased loan meets this

criteria if the loan is for an owner-occupied property in a census tract that has a median family

income less than or equal to 90% of the MSA median family income or in a census tract where

minorities constitute at least 30% of the population and median family income is no greater than

120% of the MSA median family income. Bhutta uses this discontinuity in the selection rule to

identify the impact of the GSE Act on homeownership through a regression discontinuity

analysis. Basically, he compares GSE purchase volume and overall loan volume in tracts just

71 Lawrence White, Fannie Mae, Freddie Mac, and Housing Finance: Why True Privatization Is Good Public Policy,

Draft, CATO Foundation (Washington D.C., 2004), 11.

32

below the 90% cutoff to tracts just above the cutoff. The assumption under this analysis is that

any tract characteristics affecting tract loan volume change smoothly across the cutoff except for

tract eligibility status, which changes sharply at the cutoff. As such, any discontinuity in loan

volume at the cutoff is attributable to the GSE Act.72 Bhutta uses the following graph to illustrate

the conceptual basis of a regression discontinuity test.

According to his regression analysis, Bhutta estimates that the GSE Act increases overall GSE-

eligible originations (i.e. origination of loans for homeowners targeted by the GSE Act) by about

2.7% between 1997 and 2002.73 (The relevant data is included in Table 3.) This estimated effect

“translates into about 18 extra home purchase and refinance originations, or about $2.2 million

(in 2007 dollars) in credit, per tract at the cutoff. Applying this number to the roughly 1100

sample tracts just below the cutoff establishes a lower bound on the aggregate impact of the

UAG of about $2.4 billion between 1997 and 2002” or $400 million per year during that

period.74 Although Bhutta’s study is admittedly limited to only the effect of the GSE Act on

increasing homeownership by targeted groups, the study’s quantitative analysis helps confirm the

72 Neil Bhutta, Regression Discontinuity Estimates of the Effects of the GSE Act of 1992, Federal Reserve Board

(Washington D.C., 2009), 2-11. 73 Ibid 20, 32. 74 Ibid.

33

qualitative case supporting the view that Fannie and Freddie have a limited impact on increasing

low-income and minority homeownership.

Limitations: Analysis of Benefits Omits Consideration of Fannie and Freddie Costs

Analysis of Fannie and Freddie’s public benefits offers only minimal insight about their

efficiency in serving policy goals because it excludes consideration of costs. Indeed, it is

plausible that Fannie and Freddie yield limited benefits but are still a desirable policy measure

because they are necessary to meet an important public need and even their minimal benefits

outweigh their costs. Thus, a finding that the GSEs’ public benefits are limited does not, in itself,

offer a persuasive reason to restructure them; at most, it buttresses the case for reform.

Although a benefit-cost analysis would be a better measure of Fannie and Freddie’s efficiency

than an assessment of their benefits, numerous uncertainties about the GSEs’ expected costs

would undermine the accuracy of such an analysis here. Benefit-cost analysis assesses the

productive efficiency of a program by comparing its net benefits to its net costs. If net benefits

exceed net costs, the program or policy is deemed efficient. If net costs exceed benefits,

however, the program or policy is inefficient and should be rejected.

Fannie and Freddie impose two types of social costs. First, the lower interest rates the two

housing GSEs enjoy due to an implicit federal guarantee effectively subsidizes Fannie and

Freddie. While some of this subsidy passes onto borrowers via lower mortgage rates, much of it

passes to Fannie and Freddie’s investors. As such, the share of this federal subsidy retained by

Fannie and Freddie’s shareholders is a cost to taxpayers. Second, taxpayers also bear the cost of

bailing out the two companies in case their existence is threatened due to financial troubles.

While numerous studies provide a range of cost estimates for the share of the federal subsidy that

passes to investors75, it is much more difficult to accurately estimate the cost of a taxpayer

75 Congressional Budget Office, Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac, CBO

Study (Washington D.C., May 1996); Congressional Budget Office, "Updated Estimates of the Subsidies to the

Housing GSEs," (2004); Dan L. Crippen, Federal Subsidies for the Housing GSEs, Congressional Budget Office (Washington D.C., May 23, 2001); Douglas Holtz-Eakin, "Aligning the Costs and Benefits of the Housing

Government-Sponsored Enterprises," CBO Testimony (Washington D.C.: Committee on Banking, Housing, and

Urban Affairs, April 21, 2005). James E. Pearce James C. Miller III, "Revisiting the Net Benefits of Freddie Mac

and Fannie Mae," November 2006. Wayne Passmore, The GSE Implicit Subsidy and the Value of Government

Ambiguity, Federal Reserve Board (Washington D.C., 2005).

34

bailout of the two companies. Although the federal government has agreed to extend up to $400

billion to help Fannie and Freddie meet their obligations, the actual financial implications of

federal backing to taxpayers could be a figure much larger than $400 billion or possibly even a

profit from the MBS the Treasury purchases.76 Taxpayers also bear the costs of the GSEs’

systemic risk materializing, such as illiquidity in credit markets, difficulty in obtaining loans, and

economic recession. Accurate valuation of these costs is unlikely in light of the uncertainties

regarding the future of Fannie and Freddie, recovery in the housing markets and economy, and

bank lending. Since the cost to taxpayers may well comprise a substantial portion of Fannie and

Freddie’s net costs and this cost is too difficult to estimate now, benefit-cost analysis of the two

GSEs would require too many assumptions and yield inaccurate results.

GSE Structure of Fannie & Fannie Unnecessary for Public Missions

Fannie and Freddie No Longer Needed for Secondary Mortgage Market

Fannie and Freddie were initially formed to expand homeownership and make it more affordable

almost 40 years ago through creation of a secondary mortgage market in which they could

securitize home loans and free capital available for new mortgage originations. In the 1970s and

1980s, Fannie and Freddie – and their implied guarantees – may have been needed for the

innovation and development of mortgage securitization and MBS as an efficient alternative for

residential mortgage finance.77 In the current financial markets characterized by continuous

innovation of financial products, however, Fannie and Freddie are no longer necessary to serve

the secondary market and securitize mortgages. This is clearly evidenced by the emergence of a

large secondary market in auto loans despite the lack of government intervention. Indeed, in his

discussion about the costs of retaining GSEs that have met their policy purpose, Thomas Stanton

worries that “GSEs can distort the marketplace and displace activities of the firms – here

competing lenders and guaranty agencies – that they originally were created to support.”78 Thus,

other lenders and banks should be able to expand their role in the secondary market.

76 "Suffering a Seizure: America's Government Takes Control of Freddie Mac and Fannie Mae," The Economist 8 September 2008. 77 Lawrence White, Fannie Mae, Freddie Mac, and Housing Finance: Why True Privatization Is Good Public Policy,

Draft, CATO Foundation (Washington D.C., 2004), 8, 27. 78 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American

Enterprise Institute, May 9, 2007), 1, 17.

35

The inability of the private market to develop a secondary mortgage market in the middle of the

20th century no longer explains its absence from this market. Rather, its absence is a product of

the inability of commercial banks and lenders to obtain the relatively low borrowing costs

offered to Fannie and Freddie. Former President and CEO of another GSE, the Federal Home

Loan Bank of Chicago, Alex Pollock, summarized this observation: “It is true that private

securitization of prime, conforming loans has not previously existed, but this is only because no

private firms could compete with the government-granted advantages and economic subsidies

enjoyed by Fannie and Freddie. Once past the panic and the bust, and without GSEs, there would

be a private market for securitization of high quality loans. The financial technology is not very

hard and well known.”79 Therefore, if Congress required Fannie and Freddie to freeze their

mortgage purchase activities and also loosened the capital requirements for banks to hold low-

risk mortgages, the result would likely be an expanded role of banks and other financial

institutions in the mortgage market.80

Data on Fannie and Freddie’s role in the U.S. secondary mortgage market compared to the role

of private firms confirms that the GSEs secondary market function has become less important

over time.81 In the U.S. there are roughly 50,000 census tracts, a figure that remains fairly

constant. For the year 1994, of the 23.68 secondary market purchases of conforming loans per

tract, GSEs accounted for 62% of purchases and private firms for 38% of purchases of

conforming mortgages in the secondary market. By 2004, while secondary market conforming

loan purchases per tract had risen to 90.08, the GSEs’ share of those purchases had dropped to

38% and the private market’s share steadily rose over the 10 year period to 62%, a complete

inversion of their relative roles just 10 years ago. A complete set of this data between 1994 and

2007 is included in Table 4. After conducting numerous econometric studies on such data Stuart

Gabriel and Stuart Rosenthal conclude that their estimates support the proposition that GSE

crowd out increased over time and that “high levels of GSE crowd out are a natural consequence

of the expansion and increasing sophistication of the secondary market and this is likely to be the

79 Alex J. Pollock, "The Future of Fannie and Freddie" (New York: American Enterprise Institute for Public Policy Research, February 13, 2009). 80 Peter J. Wallison, Fannie and Freddie by Twilight (Washington D.C.: American Enterprise Institute for Public

Policy Research, August 2008), 7. 81 Stuart A., Gabriel, Stuart S. Rosenthal, "HUD Purchase Goals and Crowd Out: Do the GSEs Expand the Supply

of Mortgage Credit?," 2007, 29.

36

case going forward.”82 The private sector’s ability to grow its share of the secondary mortgage

market even in spite of major GSE advantages indicates that GSEs are no longer needed to serve

that market.

Although theoretical implications of eliminating the housing GSEs’ funding advantage,

empirically supported by data on the growth of private secondary mortgage market purchases,

suggests that private institutions could serve Fannie and Freddie’s original purpose in increasing

home finance liquidity through secondary market activities, the current financial environment

undermines that conclusion. Even Stuart and Rosenthal rightly acknowledged that “changing

market conditions of course, could allow for less crowd out and a greater influence of the GSEs.

This may have been the case in the immediate aftermath of the implosion in residential capital

markets in 2007, when numerous reports indicated that private market investors became reticent

to purchase mortgage-backed debt.”83 During the past year, Stuart and Rosenthal’s prediction

proved true. As subprime mortgage lenders went bankrupt and private lenders tightened lending

standards, Fannie and Freddie’s role in providing liquidity in mortgage markets through their

role in the secondary market became even more important.84 In fact, in 2007, the GSEs financed

almost a third of the conforming market mortgage purchases, up from less than 30% only a year

earlier.85 Within the context of tighter mortgage lending standards, fewer players in the primary

and secondary markets, and little credit extended by private originators for homebuyers, it is not

clear that other investors are capable of adequately serving the secondary mortgage market. In

other words, what seemed obvious in 2004 – that GSEs were crowding out private firms who

were fully able to serve the conforming mortgage secondary market – was much less axiomatic

by 2007.

Notably, the private sectors’ present inability to take over the secondary mortgage market is

likely only a short-term phenomenon due to the present financial environment. As shown by data

cited above, the growing share of private secondary market purchases during the 1994 to 2006

period indicates that private firms have the capabilities to dominate this secondary market.

82 Ibid 25. 83 Ibid. 84 Paul A. Restuccia, Timothy P. Flynn, Understanding the Dilemma of Fannie and Freddie, Republican Caucus,

The Committe on the Budget (Washington D.C., July 17, 2008), 5. 85 Stuart S. Rosenthal Stuart A. Gabriel, "Do the GSEs Expand the Supply of Mortgage Credit? New Evidence of

Crowd Out in the Secondary Mortgage Markets," November 17, 2008.

37

Accordingly, once investors regain confidence in purchasing mortgage-backed debt and when

lenders are able or willing to lend more, it is likely that the private sector will again have a major

role in the secondary mortgage market. This prediction, however, assumes that investors and

lenders conservative behavior in the current market is temporary and will loosen under improved

economic conditions. Of course, this assumption would not hold if this change in investment

behavior is not temporary and current market conditions cause investors and lenders to

permanently adopt conservative investment practices.

Nevertheless, in light of historic shifts in risk-aversion during and after recessions in the U.S., it

is likely that this assumption will prove correct and private lending and purchasing of mortgages

will rebound as economic conditions improve. Therefore, the dominant role housing GSEs have

assumed following the 2007 housing crisis proves only a present, not permanent, need for them.

Indeed, the Treasury seems to agree that Fannie and Freddie are only temporarily valuable in the

housing market since the conservatorship plan permits the GSEs to increase the size of their

portfolios until December 31, 2009 and the Treasury agrees to loan money to them and purchase

their MBS to ensure stability and liquidity in the mortgage markets only until this date.

Therefore, once present economic barriers disappear, a secondary mortgage market comprised of

competing private firms, similar to those in auto and student loan markets, seems likely.

Fannie and Freddie Not Needed for Increased Low-Income and Minority Homeownership

Beyond their mission to serve the secondary mortgage market, the GSEs also were assigned

certain goals to expand homeownership among targeted groups, such as low-income buyers and

minorities. However, the GSE structure and the implicit guarantee are not needed to meet these

goals. In more recent years, the Congress and various administrations have attempted to shift the

focus of the GSEs to increasing home ownership by low-income families. For Fannie Mae and

Freddie Mac, that effort has largely consisted of the establishment of so-called affordable-

housing goals. Yet, as shown above, Fannie Mae and Freddie Mac continue to finance a smaller

proportion of mortgages for low- and moderate-income families than are served by the market as

a whole. They also lag behind the market in serving first-time homebuyers, especially minority

first-time home buyers, according to the Department of Housing and Urban Development

(HUD). Indeed, HUD’s latest affordable-housing goals direct the enterprises to match the

38

performance of the market in serving low- and moderate-income families by 2008.86

Fannie and Freddie’s Retained Portfolios Not Needed for their Public Missions

Due to their huge and rapidly growing retained portfolios, Fannie and Freddie are larger than

necessary to support the mission of facilitating both a liquid secondary mortgage market and

affordable housing. When these GSEs purchase mortgages from originators, they can either hold

the purchased mortgage in portfolio or bundle the mortgages into MBS. Although the first option

means GSEs must fund the purchase by issuing debt, the second does not require debt financing.

However, the first option is usually more profitable because it allows Fannie and Freddie to earn

a financing profit due to the spread between its borrowing cost and yield on mortgage loan or

MBS. While this adds to the GSEs’ earnings, it adds no value to homebuyers nor does it increase

the capital invested in housing finance. Their large mortgage portfolios holdings are not

necessary for the secondary mortgage market to operate efficiently, which can be accomplished

through MBS issuances alone.87 The VAR analysis discussed earlier offers quantitative data in

support of this proposition.88 In fact, Fannie and Freddie have aggressively sought to grow their

retained portfolios simply to maintain their earnings growth, which is unrelated to their housing

missions.89 Thus, according to Douglas Holtz-Eakin, CBO Director in 2005, if housing GSEs’

investment portfolios were reduced, subsidies would lessen, with little change in benefits.90

Privatization Optimal & Feasible Long-Term Option for Fannie & Freddie

Although various GSEs were formed to counter the threat of market imperfections to socially

desirable outcomes, by creating them to serve a specific public purpose, Congress implied that

GSEs should not exist perpetually. At some point, the GSE may have met its public mission.

Accordingly, the Treasury Department holds that “it is appropriate to wean a GSE from

government sponsorship once the GSE becomes economically viable and successfully fulfills the

purpose for which it was created with Federal sponsorship, or when the purpose for which it was

86 Douglas Holtz-Eakin, "Aligning the Costs and Benefits of the Housing Government-Sponsored Enterprises," CBO

Testimony (Washington D.C.: Committee on Banking, Housing, and Urban Affairs, April 21, 2005), 2. 87 Ibid 1. 88 Wayne Passmore, Shane M. Sherlund Andreas Lehnert, GSEs, Mortgage Rates, and Secondary Market Activities,

Federal Reserve Board (Washington D.C., 2006). 89 Bert Ely, "How to Privatize Fannie Mae and Freddie Mac," 2004, 4. 90 Holtz-Eakin (2005) 1.

39

created ceases to exist.”91 As such, when the private sector is capable of meeting the funding

needs of the particular market sector in which the GSE operated, the GSE has reached the end of

its life cycle and should be terminated.

Due to pressing macroeconomic considerations, the government’s immediate- and long-term

plans for Fannie and Freddie will have to differ. In the immediate-term, the government should

continue holding Fannie and Freddie in conservatorship to help extend much-needed credit to

qualified homebuyers by purchasing the GSEs’ MBS. Also, the government should improve the

soundness and safety of the GSEs and their systemic risk by reducing their large portfolios and

extending financing to them during this period. As such, the immediate-term is too soon to

restructure Fannie and Freddie because doing so would undermine the government’s attempt to

address pressing economic concerns.

In the long-term, however, Fannie and Freddie should be privatized. Under a 1996 legislation

that required various government agencies to publish studies on the potential effects of

privatizing Fannie and Freddie, privatization meant “repealing the Federal charters of Fannie

Mae and Freddie Mac, eliminating any federal sponsorship of the enterprises, and allowing the

enterprises to continue as fully private entities.”92 Although the procedure, structure, and timing

of privatization are clearly pragmatic issues that must be resolved, privatization is the right path

for Fannie and Freddie’s future. This finding is based on four key considerations: (1) the strength

of theoretical and policy arguments for privatizing them; (2) lessons and implications of Sallie

Mae privatization; (3) likelihood of effectively addressing the challenges to successful

privatization; and (4) the attractiveness of privatizing Fannie and Freddie in comparison to

retaining them as GSEs but limited in size by capping the amount of their retained portfolios and

subjecting them to greater regulation.

Theoretical Argument for Privatization

An individual private firm is much less likely to pose the sort of systemic risk on economic

stability and health that Fannie and Freddie have. The systemic risk these two companies impose

is a direct consequence of their GSE structure. As GSEs, the government has afforded Fannie

91 Thomas H. Stanton, "Accountability of Government Sponsored Enterprises" (Washington D.C.: U.S. House of

Representatives, July 16, 1997), 5. 92 McKinley (1997) 4.

40

and Freddie a range of regulatory, tax, and minimum capital advantages that are not available to

their purely private competitor firms. These benefits have, in turn, created a perception among

the public that there is an implicit federal guarantee to back the two GSEs’ debt and MBS

obligations. And as discussed earlier, this implicit guarantee then allowed Fannie and Freddie to

borrow money at low interest rates relative to comparable firms to fund their rapid growing

portfolios. Encouraged by cheap borrowing costs and lack of market discipline, they would

ultimately grow so large that their collapse would threaten macroeconomic stability. Therefore,

to prevent their ability to grow destructively large in the future, Fannie and Freddie should

ultimately be privatized in some form, without GSE status and, hence, their financing advantage.

Moreover, if they are restructured as private firms without GSE status, the set of assumptions

that support trusting company managers to make financially sound and safe decisions will now

also apply to Fannie and Freddie. As standard corporations, Fannie and Freddie will only have

to base decisions on shareholder interests, subject to legal obligations. Thus they will be relieved

from serving the two sets of conflicting interests in public mission and private gains. Also, since

the federal government does not implicitly guarantee the obligations of purely private firms,

privatization of Fannie and Freddie will ensure that both the risks and rewards of their activities

are borne by shareholders. As a result, Fannie and Freddie will no longer confer to shareholders

the financial rewards from their activities but burden taxpayers with their costs. Thus, without

GSE status and as purely private firms, Fannie and Freddie can continue their activities in the

secondary mortgage market but do so as companies with a set of incentives, lacking in GSEs,

that is required to ensure financially sound and safe decisions.

Sallie Mae Case Study Offers Lessons: Housing GSEs Can Be Successfully Privatized If Market

Distorting Effects Are Addressed and Key Features of Sallie Model Are Adopted

In addition to theoretical reasons, the successful privatization of Sallie Mae both serves as an

example of the benefits of privatizing GSEs and teaches important lessons about the reasons and

process to transition from a GSE to a purely private corporate structure. Given important

similarities in organizational structure and contextual developments between Fannie and Freddie

and the former GSE Sallie Mae, the latter company’s successful privatization in 1996 can be a

valuable tool in guiding the future of Fannie and Freddie. Although privatization meant loss of

its funding advantage, Sallie Mae has become a dominant force in higher education post-

41

privatization, serving as both the largest originator and largest servicer of student loans.93 It has

also benefited from being able to delve into other lines of business from which it was banned as a

GSE burdened by a restrictive charter. Further, Sallie’s loss of GSE status has not undermined its

policy goals, as student funding was abundant following privatization.

Background & Context of Sallie Mae Privatization

Sallie Mae was formed in 1972 to improve the flow of funds into student lending. By creating a

financial intermediary with access to the capital markets, Congress sought to provide a source of

liquidity to student loan lenders, who could sell their loans to Sallie Mae or obtain funding at

capital market rates using an otherwise illiquid asset as collateral. The ability to sell student loans

also allowed lenders to be active in the market without incurring the high costs of servicing.

Sallie Mae's mission from the outset was to attract private capital for the financing of higher

education.94

Resulting from a changed economic landscape and political context, five key reasons to privatize

Sallie Mae ultimately emerged:

1. Its public policy purpose had been achieved – Sallie was created primarily to provide liquidity for student loans through serving as a national secondary market and warehousing facility for student loans. The student loan market also changed significantly since the creation of Sallie Mae. It grew from a commercial bank "loss leader" to a large volume program with increasing competition and specialization. The growth of secondary markets improved the liquidity of student loans. The proportion of loans sold into secondary markets increased from less than 30 percent in the 1981 to 1985 period to approximately 60 percent in the 1988 to 1990 period. As a result, student loans were available to all qualified students. These factors strongly suggested Sallie’s primary mission, to improve the liquidity of and funding for student loans had been achieved.95

2. Increase in political risk - Investors faced a significant threat to the value of their investment from the political uncertainty surrounding the Guaranteed Student Loan program. Congress initiated a wide-reaching revamping of the existing GSL program in 1993, initiating a process to wholly or partially replace it with a direct lending program beginning in 1994. While the goal of the direct lending program was to provide 60 % of student loan originations by 1998, many believed that direct lending could eventually displace the GSL program in its entirety. As the largest single purchaser, holder, and

93 Michael J. Lea, "Privatizing a Government Sponsored Enterprise: Lessons from the Sallie Mae Experience,"

(2005). 94 Ibid. 95 Ibid.

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servicer of federally guaranteed student loans, this shift could deal a fatal blow to Sallie.96

3. Elimination of GSE funding advantage – To generate revenue for new student loan spending programs, the 1993 Omnibus Budget Reconciliation Act imposed an annual “offset fee” of 30 bps on holdings of federal student loans that Sallie acquired after the date of the Act. For loans subject to this Act, the fee largely eliminated Sallie’s funding advantage in credit markets based on its GSE status.97

4. Significant foregone opportunities associated with Sallie Mae's restrictive charter - Privatization could lead to business opportunities beyond higher education. New lines of business could be pursued by leveraging Sallie’s established market presence and expertise. Promising areas for incremental expansion included servicing for other forms of consumer loans and health care administration. Sallie would also be able to become a primary lender in education after privatizing.98

5. Elimination of dual missions - Privatization would sharpen the focus of Sallie’s management on core business issues. As a GSE, many important decisions regarding Sallie Mae’s current and future activities were made by Congress, with vastly different agenda and priorities than the owners of Sallie Mae. Privatization would reduce the control of Congress over Sallie Mae. As a result, an inordinate proportion of senior management’s time and energy was taken up in governmental relations.99

Four of the five reasons for privatizing Sallie Mae also justify privatizing Fannie and Freddie.

Like Sallie, Fannie and Freddie have also achieved their original purpose: They have expanded

affordable housing through creating a national secondary mortgage market providing liquidity to

mortgage originators. Also, new government programs that target underserved groups more

narrowly than the broad-based efforts of Fannie and Freddie without the systemic risks these

GSEs impose threaten their continued existence. Moreover, Fannie and Freddie may also

uncover new business opportunities as wholly private firms. They can originate mortgages,

purchase non-conforming mortgages, and offer loans in other industries and markets. Finally,

without GSE-status, Fannie and Freddie would no longer face a conflict between their obligation

to shareholders as public companies and their government-prescribed mission.100

96 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American

Enterprise Institute, May 9, 2007), 15-17. 97 Ibid 16. 98 Lea (2005). 99 Ibid. 100 Thomas H. Stanton, Bert Ely Peter J. Wallison, Privatizing Fannie Mae, Freddie Mac, and the Federal Home

Loan Banks: Why and How, American Enterprise Institute (Washington D.C.: The AEI Press, 2004), 20.

43

Mechanics of Sallie Mae Privatization

Sallie Mae voluntarily privatized by outlining a privatization proposal in 1994 and having it

enacted in substantial part through the Student Loan Marketing Association Reorganization Act

in 1996. Under the Reorganization Act, Sallie would be converted into a GSE subsidiary of a

non-GSE holding company. “The final winding up of the GSE’s debt obligations was done

through a transaction known as a defeasance. Under this transaction, the organization irrevocably

transferred sufficient funds or Treasury obligations to a trust and, under the trust agreement

assured that the trustee would make full repayment of all liabilities on outstanding GSE

obligations.”101 Thus, the non-GSE holding company would remove government sponsorship by

dividing its activities into two branches: (1) the new activities of non-GSE operating companies;

and (2) liquidation of GSE obligations under trust agreement. Table 5 illustrates the mechanics of

Sallie Mae’s transition from GSE to private company.

As a result of Sallie’s dominant role in the negotiations about its privatization process, the

Reorganization Act provided for a generous transition period between 1997 and 2004. Sallie Mae

could continue issuing GSE obligations that either mature on or before September 30, 2008 or

finance certain purchases requested by the Secretary of Education. While continued issuances

would help Sallie wind down over an extended period, the company was allowed to enter new

lines of business immediately. Significantly, Sallie was permitted to use profits from the GSE to

fund the holding company’s new non-GSE activities and acquisitions.102

Sallie Mae capitalized on the generous transition period to grow substantially in size and

vertically integrate its education finance market activities.103 While Sallie managed $43.7 billion

in student loans in 1997, that figure jumped to $107.5 billion by the end of the transition period

in 2004 and currently exceeds $180 billion.104 Also, mostly through a series of acquisitions,

Sallie vertically expanded from activities ranging from origination to guaranty agency services,

servicing, and collections.105

101 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American Enterprise Institute, May 9, 2007), 19. 102 Ibid. 103 Ibid 28. 104 Ibid 22. 105 Ibid 26.

44

In light of Sallie’s ability to grow and expand after its privatization, Sallie Mae remains the

largest company in the student loan business and continues to dominate the market. In 2005,

Sallie’s total assets were $99.3 billion, about four times the assets held by the next two largest

student loan companies, Student Loan Corporation ($26 billion) and Nelnet ($22.8 billion).106

Thus, despite losing formal GSE status and GSE status, the economies of scale Sallie was able to

achieve as a GSE and its retention of many characteristics of GSEs allowed it to maintain a cost

structure below competitors and dominate the market. As a result of Sallie’s post-privatization

dominance and its effect on the stability of the student loan program, the company may still be

backed by a perception of implicit government support.107

Lesson #1: Government must undo distorting effects of government sponsorship

The privatization of Sallie Mae did not result in a competitive student loan market because the

particular terms of privatization allowed Sallie to dominate its market. As Thomas Stanton

observes, unless the government acts to undo the distorting effects of GSEs in the marketplace

(i.e. displacing activities of competing lenders), “a company may make the transition to non-GSE

status while retaining the size and economies of scale that continue those effects.”108 In the case

of privatizing Sallie Mae, undoing its distorting effects required ending its market dominance

and economies of scale through reducing its size. For example, according to the Congressional

Budget Office, “Effective privatization of Sallie Mae would require dividing the firm into several

independent entities.”109 Alternatively, regulation could cap lenders’ maximum share of the

student loan market and allow other firms to develop economies of scale. Due to Sallie’s major

role in setting the terms of its privatization, however, instead of being broken up or expressly

limited in size, it retained market dominance, low cost structure, and economies of scale.110

An important lesson emerges from the Sallie Mae case for policymakers considering removal of

government sponsorship from other large GSEs: Beyond structural changes to remove GSE

status, effective removal of government sponsorship requires changes to assure a more efficient

market structure both during and after the transition from GSE status. Indeed, Thomas Stanton

106 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American Enterprise Institute, May 9, 2007), 5. 107 Ibid 38. 108 Ibid 39. 109 Ibid. 110 Ibid 39-40.

45

concludes his analysis of Sallie’s privatization with this lesson for policymakers: “they should

decide how to assure that no single institution such as Sallie Mae possesses the characteristics

that could give rise to hasty perceptions in the event of a crisis that it somehow cannot be

allowed to fail because of its dominant role in education finance.”111 Thus, in charting a path to

privatization, the terms of a privatization agreement should not only provide for the necessary

structural changes but also eliminate those attributes, like market dominance, that may allow a

newly privatized company to discourage private sector involvement even after losing GSE status.

In learning from measures that would have reduced Sallie’s market dominance for charting

Fannie and Freddie’s privatization plan, the implications of an important distinction between

student loan and mortgage markets must be considered. Elimination of GSEs’ market dominance

after privatization through capping their size or market share may prove a more costly

privatization measure for Fannie and Freddie than for Sallie. In the federal student loan market,

interest rates are administratively set by law. As such, student loan borrowers do not benefit from

lower borrowing costs from Sallie’s GSE status. In mortgage markets, however, interest rates are

determined by the market and reflect operating costs (i.e. borrowing costs). Accordingly, a share

of GSE benefits accruing to Fannie and Freddie are transferred to borrowers in the form of lower

mortgage rates. This distinction between student loan interest rates and mortgage rates is

reflected in different expected results from a market share cap: While shifting some student loan

business to firms with higher operating costs than Sallie would not increase student loan interest

rates, shifting some mortgage business to firms with higher operating costs than Fannie and

Freddie would increase mortgage rates and disadvantage homebuyers.112

Lesson #2: Privatization is possible via holding company model without causing instability

The successful privatization of Sallie Mae is a persuasive case in support of privatizing Fannie

and Freddie and offers policymakers a valuable model. Specifically, a holding company model

was used to define the process and structure for privatizing Sallie. This model provided for a

stable and orderly transition from GSE to private status without undermining the availability and

stability of credit in the student loan market, profitability in the student loan business, and

111 Ibid 41. 112 Michael J. Lea, "Privatizing a Government Sponsored Enterprise: Lessons from the Sallie Mae Experience,"

(2005); Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American

Enterprise Institute, May 9, 2007), 40-41.

46

investors’ interests.113 Given the many important similarities between Sallie Mae and Fannie and

Freddie, these two housing GSEs could be successfully privatized by adopting key features of

the proven holding company model of Sallie Mae.

A key feature of Sallie’s privatization model was a lengthy transition period. Sallie privatized

over the course of a nine-year transition period, during which it was allowed to continue many of

its activities as a GSE such as the loan purchases and debt issuances it. By allowing Sallie to

continue GSE activities during a lengthy transition period, the holding company model helped

ensure stability in the market.114 Indeed, given the continued growth and competition in the

student loan market since the Sallie privatization, it is clear that the market has not suffered from

privatizing Sallie. Student loan originations grew from $24 billion in 1994 to $52 billion in 2003.

The Federal Direct Lending Program, Sallie’s main competitor for federally sponsored student

loans, grew its market share from 4% in 1994 to 25% in 2003. Citing such data, Michael Lea

concludes: “Funding is plentiful and competition is keen.”115

A second key feature was an effective separation of GSE and non-GSE activities into two groups

of subsidiaries. This separation allowed GSE subsidiaries to continue purchasing federally

financed student loans until September 30, 2007 and assigned all outstanding GSE debt to them

(required to be wound up through defeasance by September 30, 2008.)116 It also permitted non-

GSE subsidiaries to begin new business activities immediately but prohibited them from making

secondary market purchases of federally financed student loans so long as the GSE is acquiring

these types of loans. As such, non-GSE subsidiaries enabled Sallie Mae to immediately improve

its financial soundness and stability by expanding and diversifying its business activities while

also delineating a set of Sallie obligations without government backing. At the same time, GSE

subsidiaries, the second group, provided a vehicle to retire outstanding GSE debt obligations

without affecting the status of those obligations and a continued source of student loan funds

while also limiting the contingent liability of the government in the event of borrower default to

only outstanding GSE debt subject to defeasance.117 Therefore, the separation of GSE and non-

113 Lea (2005). 114 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American

Enterprise Institute, May 9, 2007), 18. 115 Ibid. 116 Ibid. 117 Ibid.

47

GSE activities was critical to meet a range of potentially conflicting policy aims.

Recognizing the Salle Mae and Fannie and Freddie differ in some major ways, Michael Lea

concludes that “the Sallie Mae privatization model appears to be a sound blueprint for

privatization of the housing GSEs.”118 Sallie Mae and Freddie and Fannie are similar in many

relevant ways, reflected through similarities in purposes, features, and benefits of GSE status,

reasons to privatize, and privatization context. Due to their commonalities, lessons from Sallie

Mae’s privatization are applicable in charting Fannie and Freddie’s privatization path.

Specifically, the successful privatization of Sallie Mae offers two important lessons to

policymakers responsible for privatizing Fannie and Freddie. First, to effectively remove

government sponsorship, measures aimed at assuring a more efficient market structure both

during and after the transition from GSE status are necessary. Examples of such measures

include breaking up GSEs into many smaller companies and capping the size or market share of

firms in a given market. Second, privatization can be accomplished in a stable and orderly

manner and meet all stakeholder interests under the holding company model used by Sallie Mae.

The two key features of this model are: an extensive transition period and separation of GSE and

non-GSE activities in two groups of subsidiaries.

Challenges to Privatization

Reasons to privatize Fannie and Freddie – systemic risk, no continued policy purpose, ineffective

or inefficient mechanism, taxpayer contingent liability – are not new. The normative case for

privatizing Fannie and Freddie has existed since at least 1992 when legislation required a number

of government agencies to analyze privatization of the housing GSEs. However, a number of

historic barriers and theoretical concerns have prevented Congress from privatizing the GSEs. In

the past, political support for Fannie and Freddie was strong both because of the GSEs’ extensive

lobbying efforts and because they were widely supported by the public. Further, based on the

housing GSEs’ purported value through lowering mortgage rates and providing liquidity to

mortgage markets, eliminating Fannie and Freddie’s government sponsorship may, in theory,

increase mortgage rates, lower homeownership rates, and disrupt residential mortgage markets.

Nevertheless, recent political developments, changes in Fannie and Freddie, and careful design

118 Lea (2005).

48

of a privatization process and structure suggest that it is possible to overcome the historic and

theoretical challenges to privatization.

Challenge #1: Political Resistance to Privatization

Fannie and Freddie have historically been successful in leveraging the political power they wield

to prevent their privatization. Privatization would harm the interests of the GSEs shareholders

and managers. According to a 1996 CBO study, privatization would reduce the two companies’

net income and market value by more than 40%.119 This would lower the investment value for

GSE shareholders and the compensation of many executives whose earnings are partly tied to

company profits. Due to extensive lobbying and the impression held by many politicians that

Fannie and Freddie serve important housing policy goals, however, support for their GSE status

has remained strong.

When numerous reports were published in 1996 in response to legislation mandating analyses of

privatizing the housing GSEs, Fannie and Freddie reacted by combining lobbying by registered

lobbyists and executives with political ties. As a result of heavy lobbying prior to its release date,

a Treasury Report supporting privatization was revised to limit the Treasury support: “firm

conclusions regarding the desirability of ending or modifying government sponsorship of Fannie

Mae and Freddie Mac are premature.”120 In addition to pressuring government officials, Fannie

Mae alone spent $1.9 million during the first half of 1996 on lobbying costs.121 In 1999, the two

GSEs spent a combined $11 million in lobbying activities and increased political contributions to

counter political initiatives by private firms seeking to limit the GSEs’ expansion. The GSEs

have also reached beyond government circles to increase their influence. In discussing Fannie’s

decision to create 25 Partnership Offices nationwide to mainly coordinate with local political

authorities and not to conduct mortgage-related business, the GSE’s general counsel said: “For a

relatively small investment, Fannie Mae will be recognized as a force for good in each of the

cities or states. By doing so Fannie Mae will have 25 networks of support.”122 In fact, these

support networks include not only local political authorities but also the industries that benefit

119 Congressional Budget Office, Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac, CBO Study (Washington D.C., May 1996), 36. 120 McKinley (1997) 4. 121 Ibid 15. 122 Congressional Budget Office, Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac, CBO

Study (Washington D.C., May 1996), 36.

49

from the GSEs’ activities, such as home builders, realtors, mortgage bankers, and securities

underwriters.123 Former Treasury Secretary Lawrence Summers remarked: “The illusion that the

companies were doing virtuous work made it impossible to build a political case for serious

regulation.”124 As such, Fannie and Freddie have combined lobbying activities and networks of

political support to prevent changes adverse to their interests, such as increased regulation and

privatization.

Despite the historic effectiveness of Fannie and Freddie’s lobbying and networks in resisting

privatization, major developments in the political and economic landscape and operational

restrictions imposed on the two GSEs are likely to greatly reduce the political support for

maintaining their GSE status. In September 2008, the government placed the GSEs in

conservatorship due to their deep financial troubles and the risks of letting them fail.

Rationalizing the conservatorship decision, Treasury Secretary Paulson noted “There is a

consensus today that these enterprises pose a systemic risk and they cannot continue in their

current form.”125 Proving Thomas Stanton’s assertion that GSEs’ “political strength does have it

limits, especially if a GSE falters or fails,”126 pleas by the CEO of Fannie Mae to Treasury

Secretary Paulson to spare that GSE were rejected and Paulson told both companies they have no

choice in the decision.127 Moreover, under its conservatorship plan, Fannie and Freddie are

prohibited from engaging in any lobbying activities. In sum, recent economic developments have

highlighted the systemic risk the housing GSEs pose, the political support for their GSE status

has dropped, and a ban on lobbying eliminates a key source of their influence over legislation.

This new context will likely remove the political barriers to privatize Fannie and Freddie.

Challenge #2: Fear of Increased Mortgage Rates

Privatizing Fannie and Freddie may well result in higher mortgage rates for loans below the

conforming limit. If these two institutions lose their GSE status and investors abandon faith that

the government will back their obligations, their borrowing costs will increase. Fannie and

123 Thomas H. Stanton, Bert Ely Peter J. Wallison, Privatizing Fannie Mae, Freddie Mac, and the Federal Home

Loan Banks: Why and How, American Enterprise Institute (Washington D.C.: The AEI Press, 2004), 13. 124 King (2008) 5. 125 Paulson (2008). 126 Thomas H. Stanton, Government-Sponsored Enterprises: Mercantalist Companies in the Modern World

(Washington D.C.: The AEI Press, 2002), 75. 127 Stephen Labaton, Andrew Ross Sorkin Charles Duhigg, "As Crisis Grew, a Few Options Shrank to One," The

New York Times 8 September 2008.

50

Freddie’s higher interest rates on debt, in turn, will be transferred to mortgage borrowers in the

form of higher mortgage rates on conforming loans. In a 1996 report, the GAO estimated that if

Fannie and Freddie lost government sponsorship, mortgage interest rates would increase by

roughly 15 to 35 bps.128 In 2005, Lawrence White, a Freddie Mac board member during 1986-

1989, estimated the increase could be as much as 25 bps, a figure consistent with the GAO’s

prediction almost ten years earlier. The rise in mortgage rates GAO predicts if Congress

eliminates Fannie and Freddie’s GSE status translated into an additional $10 to $25 in monthly

mortgage payments for a holder of a $100,000 mortgage. Thus, concern that an increase in

mortgage rates would cause sharp disruptions in the residential mortgage market diminishes

support for privatizing Fannie and Freddie.

An increase in conforming mortgage rates does not undermine the case for privatizing Fannie

and Freddie for three reasons. First, mortgage rates will not have a significant impact on

homeownership. As shown above, a 200 bps reduction in mortgage rates raises the

homeownership rate by only 50 bps. Accordingly, the drop in homeownership is negligible in the

event privatizing the GSEs increases conforming mortgage rates by 25 bps.

Second, to the extent higher mortgage costs will reduce the homeownership rate, there are

various policy options for Congress to offset this reduction. Down-payment assistance, tax

credits or deductions, direct subsidies to mortgage originators or purchasers are just some of the

measures that could potentially facilitate homeownership. For example, a CBO study estimates

that replacing the interest rate subsidy that the GSEs passed through to borrowers in 1993 with

down payment assistance could have provided 1 million targeted households with $13,600 each.

According to the results of underwriting simulations by the Minneapolis Federal Reserve Bank,

such assistance would dramatically improve homeownership prospects of those renters.129

Third, higher mortgage rates following privatization of the GSEs will not cause sharp disruptions

in the residential mortgage market, as if the GSEs suddenly filed for bankruptcy, so long as

privatization occurs gradually. Such disruptions could be averted if the privatization plan for

Fannie and Freddie allows them to continue securitizing mortgages and provides for a gradual

128 McKinley (1997) 5. 129 Holtz-Eakin (2005) 11.

51

transition of securitization to a non-GSE form.130 Hence mortgage originators can continue

selling their mortgages to the two GSEs for later securitization. In fact, the successful

privatization of Sallie Mae demonstrates the effectiveness of a gradual transition period in

ensuring market stability. Committed to maintaining stability in the student loan market, Sallie’s

privatization plan allowed it to continue its GSE activities, such as securitization and loan

purchases, over a nine year transition period. As a result, there were no disruptions in the student

loan market: During this transition period, between 1994 and 2003, federally insured student

loan originations grew from $24 billion to $52 billion.131 Thus, since the concern that lower

mortgage rates will disrupt mortgage markets can be adequately addressed through an

appropriate transition period, it does not weaken the case for privatizing Fannie and Freddie. In

sum, if privatization occurs gradually and government utilizes alternative measures to boost

homeownership, a slight increase in conforming loan mortgage rates will not reduce

homeownership rates or result in mortgage market disruptions.

Privatization vs. Policy Alternatives

Support for privatizing Fannie and Freddie does not necessarily follow from acknowledging the

need to reform them. After the conservatorship period, Congress can choose from a number of

other options that potentially address the problems and risks of Fannie and Freddie. The housing

GSEs can be nationalized and the federal government can operate them as a wholly government

entity. Or Fannie and Freddie can remain GSEs subject to stricter capital standards, limited

portfolio size, and/or increased regulation and oversight. This study is not meant to address the

various forms each option can potentially have and exhaustively consider all benefits, costs,

risks, and challenges of each. However, it will outline reasons for the attractiveness of

privatization over policy alternatives.

Nationalization of Fannie and Freddie would effectively eliminate their conflicting need to serve

two masters and their moral hazard problem, but it does not address their systemic risk. As

government entities, they are sure to maintain – if not increase – their funding advantage,

continue to pose a systemic risk that their failure will undermine economic stability and health,

130 Thomas H. Stanton, Bert Ely Peter J. Wallison, Privatizing Fannie Mae, Freddie Mac, and the Federal Home

Loan Banks: Why and How, American Enterprise Institute (Washington D.C.: The AEI Press, 2004), 21. 131 Thomas H. Stanton, The Privatization of Sallie Mae and Its Consequences (Washington D.C.: American

Enterprise Institute, May 9, 2007), 9.

52

and crowd out private investment. They are still free to leverage cheap borrowing costs and

remain “too big to fail”. Also, if Fannie and Freddie are simply nationalized after the

conservatorship period and continue their secondary mortgage market function, they may

become a new and large source of expenses in the federal budget. To become nationalized

institutions, the federal government must substitute for the private equity investment Fannie and

Freddie relied on as GSEs. This would likely require increasing the federal debt or raising taxes,

two politically unpopular measures. Beyond costs incurred in the nationalization process, Fannie

and Freddie will continue to burden taxpayers with contingent liability in the event of default.

Although advocates of nationalization of the GSEs might argue that Fannie and Freddie can be

split into numerous government agencies to avert systemic risk, this would only increase the

government’s operational costs and complicate regulatory supervision and oversight.

Given that recent data discussed earlier suggests that Fannie and Freddie are no longer necessary

for a healthy secondary mortgage market and actually crowd out private investment in that

market, a nationalized Fannie and Freddie would represent an unjustified government

intervention and a potential budgetary expense that yields a benefit the private sector is capable

of delivering. Further, nationalizing Fannie and Freddie may leave thousands of shareholders

without any return on their investment. Lastly, more government intervention in housing through

a costly nationalization of the two housing GSEs that leaves many stakeholders unhappy is

unlikely to gain much political support.

A second alternative to privatization is to retain Fannie and Freddie’s GSE status and narrowly

focus reforms on risk avoidance and mitigation measures. These include capping their size and

growth, stricter capital requirements, and/or strengthening government regulation and oversight.

This approach perceives systemic risk as the key problem of Fannie and Freddie. Since their

systemic risk results from the GSEs’ size, it is arguably possible to maintain their GSE structure

in the future and simply impose a cap on the size of their retained portfolios. Fannie and

Freddie’s rapid growth could be traced to the growth of their retained portfolios of MBS and

mortgages. If these portfolio sizes were simply capped, the argument goes, the government could

achieve the dual mission of reducing systemic risk while continuing to ensure cheap home

finance. Systemic risk could further be addressed by imposing stricter capital requirements on

Fannie and Freddie. Capital requirements set the level of money lenders must retain in relation to

53

their debt. In the past, the housing GSEs have been allowed to hold lower amounts of capital

than private banks, which has helped fuel their growth and multiplied the systemic risk they

pose. As such, it is argued that requiring Fannie and Freddie to hold more capital will help curb

their growth. Finally, more effective regulation and oversight can improve safe and sound

decision-making by the housing GSEs. Historically, OFHEO, the regulator charged with

oversight of Fannie and Freddie’s financial condition, has been perceived as weak and

ineffective. OFHEO’s access to important information is limited and its enforcement tools are

weak. For instance, lacking sufficient data, OFHEO only learned of the GSEs’ inaccurate

accounting and reporting of key financial data only after a group of GSE executives revealed the

wrongdoing. As such, its limited access undermines OFHEO’s effectiveness in fulfilling its

financial assessment and monitoring roles. In addition to limited information access, OFHEO is

without teeth in enforcement. It has been unable to curb Fannie and Freddie’s expansion into

areas arguably beyond restrictions in their charters. Also, its efforts to increase its strength as a

regulator through enabling legislation have largely failed. Therefore, some conclude that if

OFHEO is given broader and more effective regulatory power, it can block Fannie and Freddie

from engaging in excessively risky activities and threatening macroeconomic stability.

Although such measures may reduce systemic risk, they largely ignore the two housing GSEs’

many other problems and costs. By allowing Fannie and Freddie to retain their GSE status, a

solution narrowly fixated on systemic risk does not address the problems in using private

investment to fund public missions: serving two conflicting masters and moral hazard costs.

Smaller, safer, and heavily regulated GSEs still owe fiduciary duties to shareholders whose

interests may conflict with public goals.

Also, without removing their GSE status, Congress will continue to rely on Fannie and Freddie

to increase homeownership by targeted homebuyers despite their limited effectiveness in

meeting this objective. Measures aimed at size, safety, and accountability may improve the

GSEs’ financial soundness and safety, but they will leave in place minimally effective (or

inefficient) policy vehicles. Besides ineffectively serving targeted homebuyers, as GSEs Fannie

and Freddie will continue to serve a secondary mortgage market that no longer needs them.

Furthermore, regulation has its limits. A stronger regulator will not remove the moral hazard cost

of GSEs because it cannot know enough to effectively substitute for market discipline. Despite

54

its arsenal of much more effective supervisory and compliance tools, even the Federal Reserve

has been unable to detect and prevent every major risk posed by regulated banks. Regulators

have limited resources and time to gather relevant data, evaluate a wealth of data, and perform

highly complicated analyses and forecasts. Regulators also cannot predict and preemptively

respond to every innovation that may ultimately prove costly. In the case of GSEs, moreover,

their effectiveness in lobbying political and public support has defeated efforts to subject them to

stricter regulations enforced by a stronger regulator. While a complete ban on lobbying by

Fannie and Freddie may end their direct political influence, there is a possibility that Fannie and

Freddie beneficiary groups and former networks of support will continue to lobby on behalf of

the GSEs and undermine vital regulatory reforms.

Therefore, reforms that only improve Fannie and Freddie’s regulatory context may reduce

systemic risk but ignore a range of other problems and costs due to their GSE status. In

comparison, nationalizing GSEs suffers from the inverse problem. If Fannie and Freddie became

government institutions, a range of flaws under their current structure would be addressed but a

key problem in systemic risk would remain. Privatization is the only future course for Fannie and

Freddie that both reduces their systemic risk and addresses the GSEs’ other shortcomings due to

their flawed structure, limited public value, and limits of regulation. To be clear, privatization of

Fannie and Freddie may also be an imperfect solution due to numerous factors. In the next

section, however, this study will show that many problematic factors for privatizing the housing

GSEs could be adequately addressed through an appropriate privatizing process and structure.

55

RECOMMENDATIONS

There is a clear need to reform Fannie and Freddie. Under their GSE structure, Fannie and

Freddie are an inappropriate, minimally beneficial, and unnecessary way to serve housing policy

goals. The two housing GSEs pose a large systemic risk and burden taxpayers with a potentially

huge contingent liability while offering limited public benefits and serving a role in the

secondary mortgage market that private firms can ultimately fill. Further, the needed reforms

should aim at ultimately privatizing Fannie and Freddie. Privatization is more responsive to the

GSEs’ range of problems and costs than its two main alternatives: nationalization and more

regulation of GSEs reduced in size. Ultimately, it is also a pragmatic and plausible path for

Fannie and Freddie as indicated by the successful and relevant privatization of another GSE,

Sallie Mae. In the short-term, however, the government’s policy regarding Fannie and Freddie

should be based on ensuring stability in mortgage markets and providing mortgage credit.

Based on the four findings in this report, the Federal Reserve should recommend and promote a

future course for Fannie and Freddie and their housing missions composed of three steps:

In the short-term, Fannie and Freddie should be operated as government conservatorships

and gradually privatized to ensure stability in residential mortgage markets.

Following conservatorship, Fannie and Freddie should become private companies using a

holding company model similar to that of Sallie Mae in its privatization.

Fannie and Freddie’s range of affordable housing goals should be pursued through other

policy measures and government institutions.

Short-term Focus: Mortgage Market Stability

Although private institutions have demonstrated their potential to adequately serve the secondary

mortgage market under better economic conditions, they are unlikely to serve this role in the

current environment. To the extent the government should prioritize stability in the mortgage

markets and continued credit for home finance, in the short-term it should continue its role as

conservator of Fannie and Freddie. It should explicitly back both all outstanding debt and MBS

56

obligations of Fannie and Freddie and any obligation the GSEs incur during their

conservatorship that is deemed necessary for housing credit liquidity. Fannie and Freddie should

continue purchasing and securitizing conforming residential mortgages. The Treasury should

also consider continuing its role as a funding source for these GSEs through loans and MBS

purchases past December 31, 2009 if necessary to provide the GSEs with capital for primary

mortgage market liquidity that private secondary mortgage market firms cannot yet adequately

supply or to help reduce the size of their retained portfolios.

To begin preparations before the privatization process starts, Congress should eliminate the

legislative benefits it has conferred onto Fannie and Freddie in the past. Thus, Congress rightly

eliminated their tax advantages and SEC registration and reporting exemptions. Still, for

investors to abandon belief in an implicit guarantee, Fannie and Freddie cannot remain “too big

to fail” and should be reduced in size. Before privatizing, Sallie Mae was allowed to remain a

huge institution, which ultimately undermined the elimination of all remnants of government

sponsorship. In comparison to Sallie, Fannie and Freddie are much more large and complex

institutions, all the more highlighting the need to reduce their size before privatization. As such,

the government is justified in requiring that Fannie and Freddie reduce their portfolios by 10%

annually beginning in 2010. They could reduce their portfolios in three ways of which the first

two are currently available options for Fannie and Freddie. First, the government could choose to

purchase certain mortgages and MBS. Second, private institutions and foreign governments

could buy the GSEs’ good assets. Third, if sales of portfolio assets are not enough to meet the

GSEs’ annual 10% portfolio reduction mandate, bad or toxic assets must be transferred to a

newly-created government-operated trust responsible for liquidating those assets.

This short-term conservatorship period should end when the Treasury Department determines

that mortgage markets are functioning well and that Fannie and Freddie’s financial condition is

safe and sound enough to trust that they can be operated as subsidiaries of a profitable, private

holding company. Thus, there is no set time frame for conservatorship. Upon the Treasury

Department’s finding, Congress should hold hearings to assess post-conservatorship options for

Fannie and Freddie and then vote on the GSEs’ future path. During this period, the Treasury

Department, Federal Reserve Board, and FHFA should present a united front supporting a well-

crafted privatization plan for Fannie and Freddie.

57

Privatize Fannie & Freddie Based On Holding Company Model

Following the conservatorship period, the policy focus of Fannie and Freddie should shift from

mortgage market stability to pursuing a path to privatization. With two key differences, Fannie

and Freddie’s privatization path should largely follow the successful precedent set by Sallie Mae

due to highly relevant similarities between these GSEs and use a similar holding company

model. Under this model, a holding company would be created with distinct GSE and non-GSE

subsidiaries with different operational features and regulatory limits. This separation would help

meet three objectives: (1) to ensure stability in the housing mortgage markets by continuing

former GSE activities through GSE subsidiaries; (2) to balance adopting privatization reforms by

allowing Fannie and Freddie’s non-GSE subsidiaries to engage in new activities and ensure that

these non-GSE subsidiaries do not benefit from remnants of government sponsorship in growing

too large; and (3) to retire Fannie and Freddie’s debt and MBS obligations without burdening the

new companies’ balance sheets with old GSE liabilities.

Fannie and Freddie should be owned by two different holding companies newly-created by the

government. Just like in Sallie’s privatization, these subsidiaries of the two holding companies

will continue to operate as GSEs with government backing and purchase and securitize

mortgages as needed to satisfy outstanding debt and MBS obligations. They will be prohibited

from holding large retained portfolios, however, because these portfolios do not improve

liquidity in mortgage credit markets. These two GSE subsidiaries exist solely to satisfy all

outstanding Fannie and Freddie obligations as of the date they become subsidiaries of the

holding companies. When those obligations are satisfied, these subsidiaries should be liquidated

and remaining assets and obligations should be distributed evenly among the other subsidiaries.

In addition to owning a housing GSE as a subsidiary, each holding company should also own

subsidiaries that are allowed to engage in non-GSE chartered activities, such as mortgage

origination and securitization of non-conforming mortgages. These subsidiaries will eventually

represent Fannie and Freddie’s privatized version, owing a duty only to shareholders and free to

engage in many new business activities.

However, it is important to impose certain restrictions on these non-GSE subsidiaries. First, they

should not be allowed to conduct any GSE-related activity until the GSE subsidiaries liquidate.

58

Second, they should be prohibited from acquiring or merging with other financial institutions

before liquidation of GSE subsidiaries. Third, none of these non-GSE subsidiaries’ obligations

should receive government backing and this fact must be expressly stated in the privatization

plan approved by Congress. As such, the non-GSE subsidiaries should not receive any legislative

benefits, such as those previously enjoyed by Fannie and Freddie. Unless non-GSE subsidiaries

are subjected to these three restrictions, they may benefit from an apparent government

sponsorship, discourage competitors from emerging or growing, become excessively large, and

once again pose a major systemic risk.

The privatization model for Fannie and Freddie should differ from Sallie’s holding company

model in two ways key to effective removal of government sponsorship. The Sallie Mae

precedent taught that removing government sponsorship would require not just elimination of

legislative benefits but eliminating any feature that will confer a continued funding advantage. In

the Sallie case, the privatized GSE was allowed to grow immensely during its transition to

privatization, giving rise to an investor perception that Sallie was “too big to fail” and the

government would have to back its obligation even in its private form.

First, to avoid the privatized Fannie and Freddie from obtaining a funding advantage because

they are “too big to fail” and guard against systemic risk, each holding company’s non-GSE

activities should be divided among numerous subsidiaries. Each of these many subsidiaries

should eventually become its own private company after liquidation, rather than become

incorporated under the same private holding company as in the Sallie privatization. The number

and size of these subsidiaries should aim to strike a balance between protecting against excessive

growth through numerous, small companies and avoiding managerial, regulatory, and

operational difficulties inherent in creating too many companies. Ultimately, when the GSE

subsidiaries liquidate and non-GSE subsidiaries can conduct both non-GSE and GSE activities,

they should form a set relatively small, private firms individually posing no systemic risk.

Second, the GSE subsidiaries should either be prohibited from transferring funds to non-GSE

subsidiaries or be greatly limited in the amount they can transfer. The privatized Sallie Mae

became “too big to fail” in large part due to the funds non-GSE subsidiaries received from GSE-

subsidiaries to fund new non-GSE activities during a nine-year transition to full privatization.

Thus, policy-makers should learn from Sallie’s experience and either ban or limit non-GSE to

59

GSE subsidiary transfers. Further, non-GSEs can be prevented from using GSE money to fund

their growth by requiring that each GSE to non-GSE transfer be provided to all non-GSE

subsidiaries in equal amount and at the same time. Accordingly, GSE subsidiaries will not be

allowed to fund the massive growth of one non-GSE subsidiary at the expense of the others.

Pursue Affordable Housing Goals Through Other Measures

To the extent increased homeownership and affordable housing are goals government should

pursue, it does not need Fannie and Freddie for this purpose. Earlier, this report offered evidence

of the housing GSEs’ unnecessary role, limited public value, and overly broad approach. If

securitization is critical for credit market liquidity and lowers mortgage rates, then private sector

firms will eventually serve this role. However, those lower mortgage rates have translated to only

minimal increases in homeownership. Moreover, in terms of extending credit to targeted

homebuyer groups such as minorities and low- and moderate-income households, Fannie and

Freddie have been less effective than private lenders.

Although a detailed evaluation of alternative affordable housing programs is beyond the scope of

this study, it is clear that there are more narrowly-tailored, effective, and efficient policy options

for this purpose that do not pose a systemic risk to economic health and stability and do not

burden taxpayers with an uncertain and potentially very costly contingent liability. Examples

include down payment or monthly payment assistance, an expanded role for HUD programs, a

new government agency that functions as a lender of last resort to needy or targeted homebuyers,

and increased funding for housing nonprofit organizations. Compared to Fannie and Freddie,

such programs will be reflected as expenses in the government budget and thereby lack much of

the basis for the political popularity and support historically enjoyed by the housing GSEs.

However, as recent developments have highlighted potentially huge contingent taxpayer liability

costs, these two housing GSEs did not deliver public benefits “at absolutely no cost to the

taxpayer” as Fannie’s former CEO and Chairman, James Johnson, stated to Congress in 1996.132

Thus, the case is now stronger for on-budget spending on programs that narrowly target

affordable housing goals.

132 James Johnson, Congressional testimony, April 1996

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CONCLUSION

This report has shown that in charting Fannie and Freddie’s long-term path, policymakers should

address long-held concerns about the GSEs’ risks and public costs by removing government

sponsorship. Also, analyses from various vantage points – policy-based, case study, and

feasibility evaluation – indicate that privatization is both an optimal long-term reform option for

Fannie and Freddie and a feasible one.

Specifically, this report recommends that the Federal Reserve lead a three-step privatization plan

with three different goals: (1) to successfully guide Fannie and Freddie’s transition from GSE to

privatized companies; (2) to ensure that premature or rapid privatization does not undermine

immediate-term concerns; and (3) to pursue Fannie and Freddie’s housing policy goals through

more narrowly-tailored, effective, and efficient measures that do not impose systemic risk and

contingent taxpayer liability. Although only Congress can ultimately revoke Fannie and

Freddie’s GSE charter, the Federal Reserve can lead the housing GSEs towards privatization by

collaborating with the Treasury Department and FHFA to present a united front to Congress in

support of its particular privatization plan.

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APPENDIX

Table 1: GSE Profitability Since 2006

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Table 2: Fixed Jumbo Mortgage Rates vs. All Conforming Mortgage Rates

Year Fixed-Rate Jumbo

Loans

All Conforming

Loans 1986 10.20 9.83

1987 9.50 8.99

1988 10.10 9.05

1989 10.49 9.84

1990 10.29 9.77

1991 9.53 9.09

1992 8.34 7.86

1993 7.28 6.97

1994 7.61 7.37

1995 7.98 7.73

1996 7.90 7.61

1997 7.75 7.55

1998 7.22 6.98

1999 7.28 7.18

2000 8.14 7.92

2001 7.12 6.96

2002 6.60 6.48

2003 5.88 5.69

2004 5.93 5.72

2005 6.06 5.87

2006 6.68 6.55

Period

Average

7.99 7.67

T-test 0.456021921

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Table 3:

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Table 4: Conforming Loans, Sample Means for Mortgage Market Variables

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Table 5: Sallie Mae Privatization Mechanics – Holding Company Model

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