The GSEs’ fundamental policy equation
Even as the debate continues regarding how best to regulate the GSEs, an even more fundamental GSE policy question has received far too little affirmative discussion:
Should the GSEs continue to receive the Federal benefits they do?
The question’s worth asking.
Not, mind you, in a prejudicial or partisan way, but with structure and logic.
Logically, if it exists, it must be good policy … mustn’t it?
Congress chartered the GSEs in the belief that the policy benefits outweigh the policy costs. What do the GSEs cost taxpayers? What do we get? Since costs include both expenditures made and risks incurred, the equation has three terms, as follows:
The GSEs’ fundamental policy value equation
Is A > C + R?
Does additional Affordability exceed government Cost plus systemic Risk?
Affordability = increased housing affordability to consumers compared with a baseline being achieved by the normal market
Cost = Expenditures by government, government tax expenditures, and revenues foregone by government
Risk = Financial exposure faced by the government (ergo, by taxpayers) as the expected cost of the government’s implicit political commitment to shield the GSEs (and hence their securities’ buyers or stockholders) from full market risk of their activities
Let’s examine the three elements one by one.
Now, ladies, let’s each gracefully take one
1. Affordability. Conceptually, the GSEs’ affordability benefit can be expressed this way:
How much more affordable are American homes because the GSEs’ exist?
or
What are the GSEs doing that all conventional capital sources are not?
This is an extremely difficult question to answer quantitatively, because as I’ve written extensively on this blog and elsewhere, the US affordable housing ecosystem is the world’s most complex, the most differentiated (with Federal-state-local government all involved), and therefore quite probably the most competitive.
Who’s on top now?
Currently, GSE affordability contributions are measured by OFHEO, using a formula of ‘GSE affordability goals’ that OFHEO annually prescribes (after public notice and comment) and the GSEs annually achieve. If the goals are misaimed, or the standards are set too low (and GSE critics make both charges), the GSEs could be achieving their OFHEO affordability goals — as they unquestionably do — and still not be doing much to increase affordability.
Led by the Wall Street Journal, GSE skeptics and critics abound. Since this post is pedagogical not rhetorical, I don’t propose to rehearse the issues here — probably in a future blog post.
You mean — there’s hope for another blog post?
2. Cost. This is easier to specify. The GSEs have a very nice smorgasbord of financial advantages and benefits:
All you can eat of each!
- Implicit credit subsidy: $6.5 billion annually.
- Exemption from state and local taxes: $0.7 billion annually.
- Exemption from SEC registration: $0.3 billion annually.
- Treasury line of credit: $2.25 billion (to each of Fannie and Freddie).
- Lower required capital ratio: Unquantified.
- Implicit deniable arm of the Federal government: priceless.
(A previous post explored these elements in greater depth.)
The credit subsidy reflects the lower cost of capital Fannie Mae and Freddie Mac can achieve when they sell securities in the marketplace. It’s not a Federal cash expenditure per se — Uncle Sam doesn’t have to write a many-zeroed check —
A GSE credit subsidy is a many-zeroed check
— but it benefits the GSEs just as if it were a check. And in any other context (e.g. FHA mortgage insurance), extension of credit exposure is charged an explicit OMB scoring cost, so it too is a scarce commodity.
Exemption from state and local taxes, and exemption from SEC registration, are straight cash transfers from government to the GSEs. The Treasury line of credit, although historically undrawn, is likewise worth something (most financial institutions would probably pay a point or two for such a line — in other words, $50 million a year).
Meanwhile, the fifth benefit is all too seldom noticed. By their enabling statutes (Fannie’s called the Federal National Mortgage Association Charter Act), Fannie and Freddie are not required to maintain the same capital ratios as normal financial institutions, a feature they have used to create 98%+ leverage of their equity capital, a ratio much higher than that allowed normal conventional banks (a 1.2% capital ratio is less than half what even the best (Tier 1) banks are required to maintain). Low capital ratios and high capital leverage are essential preconditions to turbocharging the balance sheet, which as we’ve seen was fundamental to generating large profits and maximizing executive bonuses.
And the sixth benefit, the dutch-uncle-sam benevolence under which the GSEs have operated, is truly priceless.
3. Risk. Ever since 1970, the GSEs have been private, stockholder-owned corporations, who make profits and distribute them to shareholders and executives. That’s fine — it’s the American way —
Vote Lex for higher profits!
— so long as the GSEs take, and the risks they run, are their own and with their own stockholders’ money.
(For all the hoopla over Enron, it’s worth remembering that it was Enron’s shareholders and employees who were affected, not taxpayers or householders. I’m not analogizing Fannie Mae or Freddie Mac’s travails to those of Enron — although others have been eager to point this out, including Fannie Mae in its litigation filing against its former auditor KPMG.)
Until heads rolled at Fannie Mae, and the story kept coming out, we thought the GSEs models of probity. Since then we’ve discovered a pattern smoothing earnings with financial tricks, suppressing criticism from within and without, apparent ‘false signatures’, and a host of further unsettling allegations.
All this would merely be depressing if it happened to a private company — but when the GSEs have charters whose impact is to involve the US government, however indirectly, as an expected source of credit enhancement, then there are substantial systemic risks that flesh is heir to, as pointed out by William Poole of the Federal Reserve Bank of St. Louis, and also by former Fed chairman Alan Greenspan, in his final pre-retirement Congressional testimony, about which I posted:
A private company trying this trick would be tested for its ability to cover an adverse swing. Since the GSEs are perceived to be protected by Congress, this doesn’t happen, so the market doesn’t charge the GSEs a premium, and hence the market doesn’t check their balance sheet growth.
These large portfolios, while enriching GSE shareholders, do not meaningfully benefit homeowners and do not facilitate secondary market liquidity.
The rate spread compression (cheaper loans) occurs at origination and initial securitization. Buying and selling existing portfolios doesn’t help the consumer. It does make Fannie Mae a ton of money, and it puts taxpayers at risk:
They do add systemic risk to our financial system, which normal market forces are unable to resolve.
New Fed chairman Ben Bernanke has expressed similar concerns. So long as the GSEs can sell their paper in the capital markets with a Federal watermark shining through it, they can take risks that the capital markets will not punish because the markets figure we’ll bail the GSEs out. That’s moral hazard in the purest economic sense, and it is incredibly worrisome.
With those three pieces, how do we make the test? And what happens if we think the GSEs fail at it?
Answers tomorrow.
[Continued tomorrow in Testing the fundamental policy value equation.]
