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Fannie and Freddie

August 4th, 2003

This light-hearted piece by Daniel Akst from the NYT raises a lot of important points about prudential regulation, quangos and related issues.

For those not familiar with the cute nomenclature of US financial markets, Fannie (Mae) was a nickname for the “Federal National Mortgage Association”, but now appears to be its official business name. Freddie (Mac) was the Federal Mortgage Acceptance Corporation, or something like that. Both are stockholder owned corporations, established with a special government charter.

In other words, these are quangos in the original sense of “quasi-non-government organisations”,private business organisations, established with effective government backing, to perform what would normally be regarded as public functions.

Among the many problems with quangos, the one emphasised in this article is the implicit guarantee from governments to bail them out if they get into too much trouble. A very similar system applies to banks under the Australian system of prudential regulation. As I observed here

Most Australians would be even more surprised to discover that there is no public guarantee of bank deposits. Under current policies, the government does not guarantee deposits, but does nothing to dispel the general belief that such deposits are absolutely safe.

As Akst observes, this kind of implicit guarantee is the worst of all possible worlds. Governments should either
(i) withdraw the guarantee;
(ii) charge a commercially-sound fee, as in deposit insurance schemes; or
(iii) take ownership of the enterprise
Akst suggests taking Fannie and Freddie into public ownership, getting their books in order and then privatising them without the implicit guarantee. This is probably the best strategy in this case.

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  1. Chris Joye
    August 4th, 2003 at 18:32 | #1

    It is nevertheless interesting to contextualise the GSE status of the likes of Fannie Mae and Freddie Mac in the US. They were, of course, responsible for the development of the secondary mortgage market, which significantly enhanced the supply, continuity and flexibility of housing finance in the US. In turn, this reduced the consumers’ cost of capital, and improved their ownership and affordability prospects. Today, mortgage-backed securities are a multi-trillion dollar asset class.

    Government supported or controlled institutions play a prominent part in the provision of housing finance in most developed countries. The largest housing finance institution in the world, the Government Housing Loan Corporation of Japan, is a public entity. The leading player in the US, Fannie Mae, is a GSE with private shareholders, a limited government charter, exemption from SEC registration requirements, and considerable fund raising and tax advantages. In this context, it is often argued that the presence of GSEs improves the liquidity of the secondary market and contributes to lower mortgage interest rates. (The absence of such certainly impeded the progress of mortgage-backed securities in Australia, as we shall see shortly.)

    There is, nonetheless, an emerging trend towards reducing public participation once some form of stability has been secured, with subsidised institutions in Argentina, Australia, France, Korea and Spain having been recently privatised. A similar pattern is beginning to manifest in the US, where popular sentiment suggests that Fannie Mae and Freddie Mac have long since matured beyond the need for government support. Indeed, on the 15th of July 2002, the US Congress embarked on a formal investigation of their comparative advantages vis-ˆ-vis aggrieved private market contemporaries. While testifying to the authorities, a Treasury under-secretary commented, The government-sponsored entities are no longer modest experiments on the fringes of our financial system·They need to be role models for investor protection, not exceptions to it.ä And so, the lesson seems to be that although public sympathy is a vital ingredient to the success of any new trading platform, there is less of a need for such support once the market gains critical mass.

    The Australian market for mortgage-backed securities first emerged in 1984, although there had been some trading since 1979 (see Wright (1989)). Today, Australia has one of the most active and innovative mortgage markets in the world. After a somewhat insipid start, it has experienced stunning growth, with roughly $80 billion in securitised mortgages outstanding as at December 2002. Default ratios are very low (less than one percent) and the high credit rating of these securities has proved attractive to investors looking for near substitutes to the diminishing government debt. The structure and legal underpinnings of mortgage-backed securities in Australia are also attractive. There is extensive use of mortgage insurance, and, as in the UK (and not in the US), there is full recourse to the assets of the individual borrower.

    Support for the secondary market in Australia was supplied at both the State and Federal levels, despite resistance to the idea in the Campbell (1981) and Martin (1983) inquiries and a great deal of initial government indifference. In fact, it is not unreasonable to suggest that the absence of coordinated government support was one reason why the market failed to gather any real momentum during the first decade.
    Notwithstanding this, progress was eventually made. State Governments variously took equity in the vehicles established to facilitate the securitisation process exempted mortgage transfers from Stamp Duties, amended legislation to enable building societies and credit unions to participate in the market, and provided trustee status to securitisation issues, which enhanced their take-up by the market.194 In April 1985, the Commonwealth Government permitted the Housing Loans Insurance Corporation to extend insurance to pooled mortgages, while precisely 12 months later they partially deregulated home loan rates. Government also indirectly assisted the asset-backed securities industry through the deregulation of the financial system, which removed other obstacles to success. So while domestic public support has been less than in the US, it was nevertheless a critical cornerstone of the marketâs ultimate growth (see Forsaith (1995)).

    Here it is instructive to reflect for a moment on the role of the major financial market participants. If the history of the Australian secondary market is any guide, they are not nearly as industrious or innovative as we might like to think. Our savings and trading banks were agnostic to say the least, and for many years played little part in the market for mortgage-backed securities. At the time, arguments offered to explain their inertia focused on the risks associated with an industry still embryonic in its development and indifference with respect to the need to securitise flexible rate mortgages. The problems appear to have been all on the supply-side, with issues marketed and underwritten professionally, and often oversubscribed. Either the mortgage originators were unaware of the advantages of securitisation or the perceived benefits were not compelling enough to motivate them to enter into the market. Perhaps it was simply a case of bureaucratic risk-aversion, and the complacency engendered by a regulated system of housing finance. Irrespective, the banksâ hegemonic stranglehold was to be short lived with the dawn of a newly competitive environment and the downward pressure this placed on fees. The arrival of spirited non-bank lenders, to whom the securitisation industry supplied a very competitive source of funding, without the need for a substantial capital base, was to focus the incumbentsâ minds and force them to offer much more attractive terms. It is no surprise that this coincided with exponential growth in the secondary market.

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