Fannie Mae Under the Gun

January 17, 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.

Want to shop for a mortgage on a level playing field?

Why Shop for a Mortgage with the Professor?

  1. Receive His Help in Finding the Type of Mortgage That Best Meets Your Needs
  2. Shop Prices Posted Directly by His Certified Lenders
  3. Shop Prices Fully Adjusted to Your Deal
  4. Shop Prices That Are Always Current
  5. Get Him as Your Ombudsman Just in Case

Read More About the Support and Protections Listed Above

Sign up with your email address to receive new article notifications


Search