W. Scott Frame
Financial Economist and Policy Adviser
Federal Reserve Bank of Atlanta
Rotary Club of Atlanta
December 15, 2008
Thank you all for inviting me to speak to you this afternoon. This is a real privilege.
Fannie Mae and Freddie Mac have become the subject of a great deal of attention and controversy. The source of this dispute lies in the institutions' unique federal charters that allowed them to become exceptionally large, profitable, and politically powerful. Recently, however, Fannie Mae's and Freddie Mac's exposure to risky mortgages compelled the federal government to intervene to stabilize both institutions and mortgage markets more generally.
Indeed, on September 7, 2008, Fannie Mae and Freddie Mac were placed into conservatorship by their federal regulator, the Federal Housing Finance Agency. And concurrent with this action, the U.S. Treasury entered into "senior preferred stock agreements" with each institution, obligating the federal government to inject up to as much as $100 billion each in Fannie Mae and Freddie Mac. Little did we know at that time, but this action would only be the first of many public-sector capital infusions for financial institutions.
In my remarks this afternoon, I will first provide you with some background about Fannie Mae and Freddie Mac. Then I will describe the sources of financial distress facing these two systemically important institutions, outline the federal government's steps to stabilize them, and present some evidence concerning the effectiveness of this and other recent federal interventions in secondary mortgage markets. At the end of my talk, I will offer some principles for federal involvement in these markets over the long term.
Who are Fannie Mae and Freddie Mac?
Fannie Mae's roots are in the Great Depression. The National Mortgage Association of Washington, as it was first known, was created within the federal government in 1938 to allow geographic diversification and improved credit availability. Its business was to purchase FHA-insured mortgages from financial institutions around the United States. Fannie Mae was subsequently spun off in 1968 as a publicly traded company as a way to reduce the federal debt during the Vietnam War. By contrast, Congress in 1970 created Freddie Mac, which was owned by the 12 Federal Home Loan Banks and the savings and loans that were members of these banks. Freddie Mac became publicly traded in 1989 as part of the resolution of the thrift crisis.
Hence, today Fannie Mae and Freddie Mac are quasi-public/quasi-private financial institutions, which are often referred to as government-sponsored enterprises, or GSEs. On one hand, each was created by Congress and maintains an exclusive federal charter. On the other hand, shares of Fannie Mae and Freddie Mac are traded on the New York Stock Exchange. This unusual governance arrangement resulted in two, often opposing, corporate objectives: fulfilling certain social policy goals and assisting related political constituencies and maximizing shareholder value.
By law, Fannie Mae and Freddie Mac are limited to operating in the secondary mortgage market. Their participation in this market takes two forms. The first is the issuance of credit guarantees against mortgage pools, called "securitization." And the second is leveraged investment in mortgages and mortgage-backed securities. As of June 30, 2008, Fannie Mae and Freddie Mac together held almost $1.8 trillion in assets and had another $3.7 trillion in net credit guarantees outstanding. This $5.5 trillion in obligations slightly exceeded the $5.3 trillion in publicly held U.S. Treasury debt at that time. It also reflects about one-half of all U.S. residential mortgage debt outstanding.
Hence, while Fannie Mae's and Freddie Mac's federal charters limit the scope of their activities, the scale is tremendous. One important reason for this is that the charters also confer several statutory and regulatory benefits that result in the capital markets viewing Fannie Mae and Freddie Mac obligations as being implicitly guaranteed by the federal government. Examples of such benefits include Treasury lines of credit, the ability to issue government securities for purposes of the Securities Exchange Act of 1934, and the ability to use the Federal Reserve as their fiscal agent.
The perception of an implied federal guarantee conveys a subsidy on Fannie Mae and Freddie Mac, part of which is translated into lower mortgage rates for consumers. These perceptions have also insulated Fannie Mae and Freddie Mac from market-imposed limits on the institutions' size and risk-taking. These features were well understood by the federal government, which created a regulatory structure for the two institutions in 1992. Unfortunately, this structure proved deficient in many respects.
Sources of financial distress
As we are all aware, housing and mortgage markets have become increasingly stressed over the past two years. This stress has led to significant dollar losses at a variety of financial institutions, including Fannie Mae and Freddie Mac. The losses borne by the GSEs emanate from four places.
The first source of losses is the write-down of the value of private-label mortgage securities backed by subprime and so-called Alt-A mortgages. (Private-label mortgage securities are those not guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae.) Holdings of such securities likely reflected a couple of factors. One is that Fannie Mae and Freddie Mac faced distorted risk-taking incentives because of the perceived implied federal guarantee. Another factor was the federal requirements that mandate a certain percent of each institution's business be devoted to affordable housing.
The second source of financial distress at Fannie Mae and Freddie Mac has been a substantial increase in provisioning for expected mortgage-related credit losses. These expected losses are associated not only with subprime and Alt-A mortgages but also prime loans.
A third problem has been a loss in the market value of each institution's holdings of their own mortgage-backed securities. An unusual and unforeseen widening of the yield spread between Fannie Mae- and Freddie Mac-guaranteed mortgage-backed securities and 10-year Treasuries has led to mark-to-market losses. This widening is believed to be primarily caused by the financial market turbulence, although the aforementioned credit problems at Fannie Mae and Freddie Mac have also likely played a role.
Finally, following the imposition of the conservatorship, both Fannie Mae and Freddie Mac wrote off so-called tax-deferred assets in line with accounting conventions required of other regulated financial institutions. This write-off was also caused by dim prospects for positive profitability any time soon.
Total losses for Fannie Mae and Freddie Mac over the past four quarters have been about $67 billion. While significant, these losses are modest relative to each institution's overall book-of-business. The problem was that both institutions were extremely leveraged, leaving little room for error. This point had been made previously, most notably by former Federal Reserve Bank of St. Louis President Bill Poole.
Earlier this year, debt investors became increasingly concerned about the financial condition of both Fannie Mae and Freddie Mac. These investors also sought clarity from the federal government about whether bondholders would be shielded from losses. The attendant uncertainty caused a dramatic fall in Fannie Mae's and Freddie Mac's share prices during June and early July. In response to concerns that the two institutions would be unable to rollover their debt, U.S. Treasury Secretary Paulson requested that the federal government be given broad authority to invest in Fannie Mae and Freddie Mac. That provision was included in the Housing and Economic Recovery Act that passed in July 2008.
During August, the U.S. Treasury studied investment options and sought third-party opinions about the financial conditions at Fannie Mae and Freddie Mac. The Treasury also engaged the Federal Housing Finance Agency (FHFA) in discussions about the legal and operational hurdles to government involvement at one or both institutions.
On September 7, FHFA Director James Lockhart, U.S. Treasury Secretary Henry Paulson, and Federal Reserve Chairman Ben Bernanke spoke at a press conference. These officials outlined a plan to stabilize the residential mortgage finance market that included placing both Fannie Mae and Freddie Mac into conservatorship and establishing new Treasury-operated liquidity facilities aimed at supporting the two institutions—a mortgage-backed securities purchase facility and a standing credit facility.
By becoming a conservator, the FHFA assumed the responsibilities of the directors, officers, and shareholders of both Fannie Mae and Freddie Mac. Also, new chief executive officers were named to act as agents of the conservator.
Concurrent with the conservatorships, the U.S. Treasury entered into a senior preferred stock agreement with each GSE. The purpose of the agreements is to ensure that Fannie Mae and Freddie Mac maintain positive net worth going forward. If the regulator determines that either institution's liabilities exceed assets under GAAP, the Treasury will contribute cash capital equal to the difference in exchange for senior preferred stock. Each of these agreements is of an indefinite term and for up to $100 billion.
In exchange for the senior preferred stock agreements, the Treasury received from each Fannie Mae and Freddie Mac $1 billion of senior preferred shares and warrants for the purchase of common stock representing 79.9 percent of each institution on a fully diluted basis. The agreements also included various covenants.
Effect on mortgage rates
The intent of the senior preferred stock agreements was to provide comfort to Fannie Mae's and Freddie Mac's senior and subordinate creditors and holders of mortgage-backed securities. This action, in turn, was expected to lower and stabilize the cost of mortgage finance. Of course, the senior preferred stock agreements had significant negative consequences for stockholders.
The initial market reaction to the federal intervention at Fannie Mae and Freddie Mac was tighter spreads on each institution's debt and mortgage-backed obligations. Related to this, conforming mortgage rates fell by about 50 basis points. These market reactions, coupled with a relatively smooth operational transition, suggested that the imposition of conservatorships at Fannie Mae and Freddie Mac was, so far, a success.
However, by the first of November, mortgage rates and yields on Fannie Mae and Freddie Mac obligations had climbed back to preconservatorship levels. Policymakers searched for additional tools to lower and stabilize the cost of mortgage finance. In response, the Federal Reserve announced November 25 that it was establishing new facilities to purchase up to $500 billion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, and purchase up to $100 billion in debt obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System.
The federal intervention into Fannie Mae and Freddie Mac consisted of both the imposition of conservatorship regimes and the senior stock purchase agreements. Congress will likely need to pass new legislation to move these institutions out of the current arrangements. Today's consensus is that the previous public-private business model is inherently flawed and unstable.
Indeed it is unclear what role Fannie Mae and Freddie Mac will ultimately play in the U.S. housing finance system. And the reasons for this uncertainty do not solely rest with the two enterprises. The financial distress at Fannie Mae and Freddie Mac has occurred along with significant and well-publicized problems at private mortgage insurance companies, monoline bond insurers, and a host of mortgage originators. The federal government has stepped in to fill some of this void. FHA-insured mortgages have increased as a share of mortgage originations, and Ginnie Mae securitization activity has similarly expanded. Hence, the federal government may need to redefine its role in supporting secondary mortgage markets.
Secondary mortgage markets can help reduce mortgage rates by increasing liquidity, allowing geographic diversification, and encouraging competition. The federal government played a historically important role in developing these markets—both directly through Ginnie Mae and indirectly through Fannie Mae and Freddie Mac. However, based on my research, I conclude the reliance on secondary mortgage markets has probably been excessive, owing to a couple of factors. One factor was regulatory capital requirements for GSEs and depository institutions that encouraged more securitization than otherwise would have been the case. Another factor was the weak mitigation of the numerous conflicts-of-interest inherent in the originate-to-distribute model of financial intermediation.
Looking ahead, I think it would be helpful for the federal government to develop a set of principles to guide its involvement in secondary mortgage markets. Among other things, I believe that policymakers should reassess various public policies encouraging homeownership, reconsider the mechanisms relied upon for ensuring the flow of funds to mortgage markets during times of stress, revisit regulatory policies that act to distort financial risk-management decisions, and require that any interventions are made transparent by accounting for them in the budget process.
The past two years have been a time of extraordinary upheaval for U.S. mortgage markets. In my opinion, the associated adjustments are likely to continue in 2009 as the new Administration and Congress take the lead in further action to stabilize our nation's mortgage finance system.