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17 January 2005
The Accounting
Scandal at Fannie Mae
"The media has been full of stories recently
about accounting scandals at Fannie Mae�Is this another Enron? What does it mean
to John Q. Public?"
It is an accounting scandal, and heads
have rolled as a result, but it is not another Enron.
The phony accounting at Enron concealed
massive losses whereas the phony accounting at Fannie Mae concealed large
fluctuations in income. Absent the phony accounting, Enron was insolvent, but
Fannie remains solvent and very strong, if not quite as strong as it had
appeared earlier.
Yet there is more at stake in the Fannie case
because Fannie Mae is a "Government-sponsored enterprise". While Fannie and its
smaller sister agency Freddie Mac have private shareholders and their employees
are not under civil service, they enjoy important Government supports. These
include a line of credit with the Treasury Department and use of the facilities
of the Federal Reserve.
For this and other reasons, the market
believes that the Federal Government implicitly guarantees the obligations
issued by Fannie and Freddie, so they can raise funds at a lower cost than any
private firm. This cost advantage results in market dominance. No strictly
private firm can compete with them in purchasing and reselling "conforming"
mortgages which meet their requirements.
The flap about accounting has had one
favorable consequence: Questions about the unique role of Fannie and Freddie in
the US housing finance system are now being actively discussed. Your question
about the impact on John Q Public provides a useful way to get at these
questions, but we must distinguish John Q. as borrower, tax payer and citizen.
The Public Stake
in Fannie Mae and Freddie Mac: Borrowers
Fannie Mae and Freddie Mac reduce the costs
of borrowers who meet the underwriting requirements of the agencies, and who
need loans no larger than the largest mortgage the agencies are allowed by law
to purchase. For 2005 the maximum is $359,650. It is raised every year in line
with increases in home prices.
To determine the size of this benefit, on
November 1, 2004 I shopped at 4 on-line web sites for 15-year and 30-year
mortgages of $320,00 and $350,000 which were otherwise identical. Since only the
smaller loan was eligible for sale to the agencies � the maximum loan in 2004
was $333,700-- the price difference between them is entirely attributable to the
difference in eligibility. Detailed results are shown in the table at the end of
this article.
After adjusting for small differences in
upfront fees, I found that the rates on the smaller mortgage generally ranged
from .25% to .375% lower than the rates on the larger mortgage. This amounts to
payment reductions of 1.7% to 2.5% on 15-year loans, and 2.7% to 4.1% on 30-year
loans.
These are not trivial differences, but they
are not dramatic either. Market rates often change by this amount or more
without attracting a great deal of attention.
In addition to reducing interest rates in a
sizeable segment of the market, Fannie and Freddie have been required by
Congress to target borrowers with low-to-moderate incomes, and/or residing in
underserved areas. Every year, the Department of Housing and Urban Development
(HUD) sets a target for the percent of the agencies� mortgage purchases that
ought to be accounted for by targeted borrowers. How many of these loans would
not be made without the agencies� support, however, is never clear.
The Public Stake
in Fannie Mae and Freddie Mac: Taxpayers
While John Q as borrower benefits from Fannie
and Freddie, John Q as taxpayer could end up paying the bill.
The agencies reduce interest rates on the
mortgages they purchase because they can raise the funds they need at costs only
marginally higher than those paid by the US Treasury, and well below the cost of
funds to any AAA-rated private corporation. The reason for the low cost is that
investors believe that Fannie and Freddie have a special claim for Government
assistance in the event they ever get into financial trouble.
This perception is well-founded. Since the
failure of the agencies to meet their obligations would be catastrophic, there
is no doubt that Government would step in to prevent it. If that were to happen,
you and I would be on the hook for the cost. Taxpayers paid for the savings and
loan debacle of the 80s, and this one could cost even more. Different views on
how this is best prevented are discussed below.
Avoiding Taxpayer
Bailouts With Stronger Regulatory Controls
John Q Public as citizen seeks the best
possible way to protect taxpayers while minimizing hurt to borrowers.
The agencies themselves take the
position that nothing need be done, because they will keep themselves safe and
sound. In contrast, most informed observers outside the agencies opt either for
stronger regulatory control, or for full privatization.
Those favoring stronger regulatory control
believe it could prevent the agencies from getting into the kind of trouble that
would require Government intervention. This is the view of OFHEO, the existing
regulator, which has struggled to convince the Congress that it is "tough
enough" to regulate the agencies. Support for this approach also comes from some
industry players, who expect that tighter regulation will include curbs on the
agencies� expansion into new markets where the players don�t want them. Congress
also appears favorably disposed to tighter regulation.
The basic problem with the regulatory
approach is that it could easily fail, as it did with the savings and loans,
which were a regulated industry. One major reason that regulation failed in that
case was that the safety and soundness objective of the regulators was
undermined by a broad public policy that prevented savings and loans from
writing adjustable rate mortgages. That policy was not changed until after most
of the damage had been done.
The current arrangement for regulating Fannie
and Freddie has an eerily similar conflict. One regulatory arm is focused on
safety and soundness, the other on meeting the mortgage loan needs of the
disadvantaged. Maybe this will work, but the history of financial institution
regulation suggests that the risk is high that it will not.
Avoiding Taxpayer
Bailouts With Full Privatization
The major argument for full privatization is
that a private firm whose debts are neither implicitly nor explicitly guaranteed
by the Government could fail without tax payers having to foot the bill.
Further, there is no rationale today for a
Government-supported but privately owned duopoly. This type of structure harkens
back to the beginnings of the country, when every corporation required a special
charter from the state that spelled out its privileges and responsibilities in
detail. That approach ended with the enactment of general incorporation laws,
but here it is again with Fannie Mae and Freddie Mac.
This was a historical accident. Both Fannie
and Freddie began life as Government agencies, and the switch to private
ownership (while retaining Government support) was designed to encourage
development of a private secondary mortgage market. That was a reasonable
rationale at the time, but no longer because the objective has long since been
achieved.
Many firms are active today in purchasing
mortgages that are not eligible for sale to Fannie and Freddie, but theirs is a
small part of the total market. The larger part belongs to the agencies, which
are safe from the competition of firms that don�t enjoy their privileges.
Making The
Transition
The challenge is to remove
Government support without hurting investors who have relied on that support. We
also want to avoid damaging the agencies because after full privatization, they
will be obliged to compete with other private firms.
My proposal is to have the Government
explicitly guarantee all the outstanding obligations of the agencies as of a
specified transition date. The credit lines the agencies now have with the
Treasury would be revoked on the same date. These actions prevent repercussions
in financial markets, yet put markets on notice that new obligations are not
guaranteed.
Over time, the volume of guaranteed claims
would gradually decline. The existing segmentation of the secondary market into
a large piece controlled by the agencies and a small piece with many players,
would end.
There are good arguments on all sides of the
debate about what to do with Fannie and Freddie, but there are no good arguments
for the status quo. Those who believe that the Government-supported private firm
model is a good one should be proposing that we expand their number. I have
never heard a reasoned defense of why the privileges of Government sponsorship
should be limited to two behemoths.
Price Difference Between
Conforming and Non-Conforming Mortgages, November 1, 2004
|
Lender |
15-Year |
30-Year |
| |
$320,000 |
$350,000 |
Diff |
$320,000 |
$350,000 |
Diff |
|
Eloan |
|
|
|
|
|
|
| Rate |
5.125 |
5.500 |
.375 |
5.625 |
6.000 |
.375 |
| Points |
-.329 |
-.223 |
.106 |
-.116 |
-.024 |
.092 |
| APR |
5.131 |
5.525 |
.394 |
5.650 |
6.034 |
.384 |
| |
|
|
|
|
|
|
|
Mortage ETrade |
|
|
|
|
|
|
| Rate |
4.875 |
5.125 |
.250 |
5.500 |
5.750 |
.250 |
| Points |
-.250 |
-.375 |
-.125 |
-.250 |
0 |
.250 |
| APR |
4.914 |
5.238 |
.324 |
5.526 |
5.790 |
.264 |
| |
|
|
|
|
|
|
|
Indy Mac |
|
|
|
|
|
|
| Rate |
5.000 |
5.250 |
.250 |
5.625 |
5.875 |
.250 |
| Points |
-.125 |
0 |
.125 |
-.125 |
-.137 |
-.012 |
| APR |
5.092 |
5.352 |
.260 |
5.681 |
5.926 |
.245 |
| |
|
|
|
|
|
|
|
HomeLoanCenter |
|
|
|
|
|
|
| Rate |
4.875 |
5.25 |
.375 |
5.500 |
5.875 |
.375 |
| Points |
-.250 |
0 |
.250 |
-.250 |
0 |
.250 |
| APR |
4.976 |
5.349 |
.373 |
5.563 |
5.937 |
.374 |
Quotations refer to loans to borrowers with excellent credit purchasing a
$500,000 single-family home in California for permanent occupancy, with taxes
and insurance escrowed, price locked for 30 days except for Indy Mac which locks
for 40 days. Price quote is for points closest to zero.
Copyright Jack Guttentag 2005
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