Government-sponsored Enterprises: Fannie Mae and Freddie Mac
Carlos M. Pelaez
In a perfectly competitive economy maximum efficiency is attained when the economy produces output for all goods and services at which price equals marginal cost. The definition of marginal cost is the increase in cost resulting from the production of an extra unit of output of goods or services. Costs include normal profits or the remuneration required for entrepreneurs to organize production. Government intervenes directly by fixing maximum or minimum prices of goods and services.
First, the fixing of prices by the government below marginal cost, or maximum price, causes a shortage or less output of the good or service than optimal. The sale of an extra unit brings in a price that is lower than the cost of producing that extra unit, resulting in a loss, such that the extra unit is not produced. New York real estate prices are frozen for certain residences but not for new construction. The city has had a perennial housing “shortage” with the coexistence of frozen rents of a few hundred dollars with monthly rents of $6000 for a two-bedroom apartment. The elimination of frozen rents would increase construction to the point where the cost of housing in the city would move toward the optimum. There is a social welfare loss because output or construction is less than what is required by the preferences (needs) of society.
Second, the government can also fix a minimum price above marginal cost. The producer would increase output because an extra unit of production, or price, would bring in more revenue than what it costs, or marginal cost. In this case there is a surplus of unsold output. Agricultural support programs in the US by minimum prices caused perennial unsold surpluses purchased and stockpiled by the government. The situation is more complex when the supply of the good or service depends on past prices. For example, the coffee tree planted today only provides full output in three years. Brazil had a majority share of world coffee output and engaged in withdrawals by the government of coffee from the market after 1906 to maintain high prices that induced higher production in a few years as analyzed by Antonio Delfim Netto (Pelaez, ed., Essays on Coffee and Economic Development). The continuing support of coffee prices eroded Brazil’s advantage by encouraging other producers that gained market share. There is a welfare loss in that capital, labor and natural resources are used to produce more than what is desired (needed) at the expense of other goods that could have been produced. There is also a transfer of income from taxpayers to the subsidized producers benefitting from the minimum prices.
The current credit/dollar crisis and global recession originated in one of the largest subsidies in US history that caused overproduction of housing. The various forms of this housing subsidy or minimum housing price occurred as follows (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4):
●30-year Treasury Bond. On August 9, 2001, Treasury ceased the auction of the 30-year Treasury bond and did not auction this security again until August 2005. The objective was to reduce mortgage rates in an effort to lower monthly payments of mortgages that actually injected more money effectively in homeowners’ pockets than through tax rebates. The 30-year Treasury is used as an asset to match the liabilities of long-term contracts such as pensions. The sudden disappearance of new 30-year Treasury bonds caused an increase in demand for mortgage bonds that raised their prices, which is equivalent to a reduction of mortgage rates (Pelaez and Pelaez, Government Intervention in Globalization, 52-6).
●Zero Interest Rate. The fed funds rate is the rate at which banks sell to each other excess reserves deposited at the Federal Reserve Banks (FRB). The fed funds rate is an approximation of the marginal cost of funding of banks and influences the levels of most other rates charged by banks to their clients. The Fed lowered the fed funds rate by decrements in periodic meetings of the Federal Open Market Committee (FOMC) from 6 percent on January 3, 2001, to 1 percent on January 25, 2003, maintaining it at that level until June 30, 2004, and then raising it in increments to 5.25 percent by June 29, 2006. The lowering of the fed funds rate to 1 percent and the announced intention of lowering it to zero if required in avoiding deflation that never materialized distorted the calculations of risk and return in almost every activity in the world. Near zero interest rates encourage excessive debt with risk priced at very low levels; low liquidity and leverage are induced because of the hunt for high yields to remunerate capital. The flood of cheap liquidity encouraged unsound credit. The rapid increase in rates from 1 percent to 5.25 percent shows the current Fed trap of lowering rates close to zero because of the pain caused by their subsequent sharp increase.
●Housing Subsidy. Dwight Jafee and John Quigley published in the Brookings-Wharton Papers on Urban Affairs of 2007 an estimate of the US housing subsidy in 2006 of $221 billion composed of $37.9 billion in government expenditures for low-income housing, $156.5 billion in federal tax subsidies for housing and $26.7 billion in credit subsidies (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 44, Regulation of Banks and Finance, 219).
●Fannie and Freddie. In 1990, the total portfolio of Fannie and Freddie amounted to $604 billion of which $135 billion in the retained portfolio and $604 billion in guarantees of mortgage-backed securities (MBS) equivalent to 25.4 percent of total mortgages in the US of $2911 billion. In the third quarter of 2008 the total portfolio stood at $5243 billion of which $1498 billion in the retained portfolio and $3744 billion in guarantees of MBS equivalent to 43.5 percent of total mortgages in the US of $12,057 billion (data from the OFHEO in Pelaez and Pelaez, Financial Regulation after the Global Recession, 45).
The Chief Economist of the National Association of Realtors (NAR) estimates that the loss of homeowner equity from the peak of house prices in 2006 to mid 2009 accumulated to $5.5 trillion (http://www.realtor.org/research/economists_outlook/commentaries/ehs0609ly ). The loss is equivalent to 38.9 percent of estimated GDP for 2009 of $14,140 billion. Total house value in the US stood in mid 2009 at $17 trillion about equal to the value in 2003. The gain in home equity between 2000 and 2005 was $4 trillion (calculation of the NAR cited in Pelaez and Pelaez, The Global Recession Risk, 224). This fluctuation in home values can be explained by the above factors. Mortgage rates declined significantly from 7.91 percent in 1999 to 6.68 percent in mid 2006 (Pelaez and Pelaez, The Global Recession Risk, 224, citing data of Freddie Mac). Part of the decline originated in the more benign inflation environment but it was reinforced by the discontinuance of the auctions of 30-year treasuries, the zero interest rate, the housing subsidy and the operations of Fannie and Freddie. Lower mortgage rates and accessibility to housing loans in the flood of cheap credit attracted homeowners and investors, causing significant increase in demand for houses and thus their prices. As in the case of agricultural commodities, construction of a house takes time from the initial decision as developers plan projects, buy land and begin building and marketing of houses for future delivery. The $4 trillion gain in homeowner equity calculated by the NAR reflects the increase in house prices that motivated more construction. More units kept on reaching the market after prices began declining.
In testimony before the US House of Representatives on December 9, 2009, the former chief credit officer of Fannie Mae, Edward Pinto, stated that Fannie and Freddie purchased about half of the outstanding 25 million nonprime mortgage loans in the value of $4.5 trillion with leverage ratio of 75:1 (cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 46, Regulation of Banks and Finance, 80). Nonprime mortgages were purchased or guaranteed by what turned out to be the US federal government (taxpayers) as everybody anticipated. The zero interest rate of the Fed created the impression that housing prices would increase forever. Homeowners believed that the downside was to live in a better residence for a couple of years before reset of mortgage rates and principal and then sell the house for a capital gain after repaying the mortgage. Lenders believed that the downside was early repayment of the mortgage or sale at market value in foreclosure. Low interest rates caused high house and stock prices making everybody feel artificially wealthier (Pelaez and Pelaez, Financial Regulation after the Global Recession, 234-6, Regulation of Banks and Finance, 175-7, Globalization and the State Vol. II, 212, Government Intervention in Globalization, 183). Mortgagors began defaulting after the peak in prices in 2006. Many of the nonprime mortgages were in MBS and derivatives known as collateralized mortgage obligations (CDO) that were financed with commercial paper issued by structured investment vehicles (SIV) often related to banks (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The origin of the credit/dollar crisis was the default of mortgages because of the minimum price to housing artificially created by zero interest rates, the housing subsidy, Fannie and Freddie and not the financial innovations in securitization and structured products or irresponsible bankers.
Over the last nine quarters Fannie lost $120.5 billion and Freddie lost $67.9 billion (reported by www.bloomberg.com on December 25, 2009). On December 24, 2009, Treasury announced the elimination of the limit of $200 billion each for Fannie and Freddie of Treasury equity infusions that can now exceed the combined $400 billion of which the two companies have used $111 billion. Ideal and critical regulatory change should consist of gradual sale of the portfolios of Fannie and Freddie, returning residuals if any to shareholders. Housing subsidies if any should be incorporated in the federal budget but there should not be government-sponsored enterprises taking major risks that cause shocks in housing and financial markets. Guarantees of mortgages if any could be considered by Congress in a federal agency with prudent management and supervision. The heavy regulatory agenda focuses on irresponsibility of bankers in pursuit of bonuses but has ignored the actual causes of the credit/dollar crisis and global recession. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)