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Fri Feb 18 10:03:55 PST 2005

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BUILDING THE AMERICAN DREAM...OR NIGHTMARE?
Feb 18th 2005  

The Fed's chairman, Alan Greenspan, has urged Congress to do something
to rein in America's two monster mortgage-finance agencies, Fannie Mae
and Freddie Mac, before they put the country's financial system at risk 

FANNIE MAE and Freddie Mac, the twin titans of America's mortgage
markets, think of themselves as big, friendly giants. They stand behind
the mortgages of around three-quarters of America's households--they
"make home possible," as Freddie Mac likes to put it. Their circle of
friends does not, however, extend to the Federal Reserve and its
chairman, Alan Greenspan. On Thursday February 17th, he told Congress
that by letting these two agencies grow unchecked, "We are placing the
total financial system of the future at a substantial risk." Very big
but not so friendly, these giants could soon loom over America's
financial skyline like Godzilla and King Kong.

Fannie Mae--originally the Federal National Mortgage Association, it
now calls itself by its chummy Wall Street nickname--traces its origins
to the credit crunch of the Great Depression, and government efforts to
help families borrow to buy a home. Fannie Mae, and its smaller cousin,
Freddie Mac (the Federal Home Loan Mortgage Corporation), do not lend
to budding homebuyers directly. Instead, they buy up the mortgages that
other lenders offer, helping local banks and thrifts to distance
themselves from the risks involved. Some of these mortgages are then
bundled up and sold on: the agencies serve simply as middlemen. But a
growing proportion are kept on the agencies' balance sheets. Between
1997 and 2003, their combined holdings more than trebled, to over $1.5
trillion (see chart). The middlemen have got fatter and fatter.

Why are they so financially retentive? To provide liquidity and
stability to the American mortgage market, a Freddie Mac spokesperson
told Reuters news agency. To make money, Mr Greenspan told Congress.
Though the two agencies are owned by private shareholders, they are
widely perceived to enjoy an implicit guarantee from the federal
government. This lets the agencies borrow cheaply to buy mortgages,
squeezing out any unsubsidised rival which has to stand on its own
feet. Whatever the official position, since the two agencies are now so
big, the federal government will in fact be forced to bail them out if
things ever do go wrong.

How might things run awry? As an asset, mortgages pose three risks: the
interest rate can fall, the mortgage can be repaid early, or the
homebuyer can default. To cushion themselves against these risks, the
two agencies hold a reserve of capital. But in Fannie Mae's case, this
cushion was judged too threadbare by the agency's main regulator, the
Office of Federal Housing Enterprise Oversight (OFHEO). It ordered
Fannie Mae to raise its capital cushion by 30%. The two agencies thus
stopped adding to their piles of mortgages at quite such a furious rate
last year. But once this moment of crisis passes, Mr Greenspan says,
the portfolios will grow again.

On Thursday, Mr Greenspan urged Congress to step in and cut the two
agencies down to size. If "immediate divestiture" of their mortgage
holdings would be too abrupt, their portfolios should nonetheless be
slimmed down over several years. His words wiped more than 2% off
Fannie Mae's share price, and 3% off Freddie Mac's.

The chairman's words have hurt the two agencies before. Last year, the
Fed chairman suggested homebuyers should take out flexible-rate
mortgages, rather than fixed-rate. This is questionable advice for
homebuyers, but it is unquestionably bad for Fannie Mae and Freddie
Mac. Borrowers, who are averse to risk and often overexposed to
mortgage debt, pay a premium for the security of a constant stream of
interest payments, a premium Fannie Mae and Freddie Mac are happy to
pocket.

The implicit guarantee the agencies exploit accounts for half of their
stockmarket value, according to Wayne Passmore, an economist at the
Fed. But only a small fraction of this subsidy is passed on to
homebuyers in the form of cheaper mortgages. The rest is pocketed by
the agencies' shareholders. This is, said Mr Greenspan last year, an
"opaque and circuitous" way to subsidise homeownership.

Does homeownership deserve a subsidy at all? Politicians argue that
homeowners are better citizens, more committed to their communities.
That is partly true: in America, the transaction costs of selling a
house can claim up to 10% of the value of the home, leaving people
reluctant to pick up and move. But is immobility necessarily a good
thing? When jobs move people should follow them. But homeowners, rooted
in their neighbourhoods, are also rooted to the spot. They cling to the
side of a sinking neighbourhood, long after the jobs have jumped
overboard. As Andrew Oswald, an economist at the University of Warwick,
in England, points out, West Virginia has one of the highest
homeownership rates in the Union; it also tends to have one of the
highest rates of unemployment.

Fannie Mae likes to say that "Our business is the American dream".
Homeownership is undoubtedly popular with Americans and their
politicians. But if the Fed chairman is right, these two dream-builders
should be keeping financial regulators awake at night. 

See this article with graphics and related items at http://www.economist.com/agenda/displaystory.cfm?story_id=3686475&fsrc=nwl

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