It's not every day that a treasury secretary intentionally tries to rattle the massive bond market. But that's what John Snow did last week. The treasury secretary told a gathering of bankers that Fannie Mae and Freddie Mac, the two government-sponsored enterprises that dominate the nation's mortgage markets, were not "too big to fail." Fannie and Freddie enjoy congressional charters, exemptions from state and local taxes, and access to Treasury credit lines, but they are otherwise regular companies. Investors are deluded if they believe the trillions in debt issued by GSEs come with an implicit or explicit government guarantee. "The reality is that the market treats the paper as if the government is backing it," he said. "We need to disabuse people of that perception. Investments in Fannie and Freddie are uninsured investments."
The statement, which amplified similar comments made recently by Federal Reserve Chairman Alan Greenspan, seemed a calculated effort to throw into turmoil what has become the single largest component of the bond market—there are now more mortgage-backed securities sold each year than U.S. government bonds.
But the capital markets ignored Snow. Even after his comments, Fannie Mae and Freddie Mac debt continues to trade at interest rates above Treasury bonds—which are absolutely guaranteed by the feds—and below high-rated corporate bonds, which enjoy no government guarantee.
Why are Snow and Greenspan attacking the entities that have made the highly stimulative refinancing boom possible? And why are others who benefit from the GSEs also complaining about them?
The GSEs have brought some of the criticism on themselves. Freddie Mac has been plagued by accounting scandals and concerns over executive compensation. The fact that Fannie Mae is run by former Clintonite Franklin Raines may place the company on the hyperpartisan Bush economic crowd's enemies list.
But the anti-GSE campaign has more to do with Fannie and Freddie's successes than their failures. For Snow, the entities have become so big and so important to everything from the housing market to international capital flows that they must be either reined in or placed under heightened surveillance. GSEs today back more than three-quarters of single-family mortgages. GSEs have also become one of the chief pipelines through which the United States imports foreign capital. Foreigners buy GSE debt because they think it is nearly as safe as T-bills. No one in the U.S. government wants them to stop buying it. In January, according to the Treasury Department, GSE debt accounted for $23.3 billion of the net $100.2 billion in foreign purchases of domestic securities. Given this, Snow argues, the government can't afford to let the Office of Federal Housing Enterprise Oversight, a unit of the Department of Housing and Urban Development, continue to have exclusive regulatory oversight of the GSEs. Indeed, Snow made his anti-GSE comments as part of a larger brief that OFHEO "be replaced by a stronger regulator"—i.e., the Treasury Department.
Commercial banks also gripe about the GSEs while milking them for benefits. They complain that Fannie Mae's implicit government backing gives it an unjust financing advantage and thus steals market share from their own home-lending business. But commercial banks routinely pack their own portfolios with mortgage-backed securities as a way of goosing their returns without having to go to the trouble of making loans. According to the Federal Deposit Insurance Corp., commercial banks hold about $1.1 trillion in GSE-related debt, equal to 12 percent of their total assets. And the private banks take full advantage of that implicit public guarantee. FDIC-insured banks face limits on the amount of higher-yielding corporate debt they can hold, but they can own as much government debt as they like. For regulatory purposes, the Fannie and Freddie debt is counted as government debt.
And GSEs provide an important cover to banks. Part of the GSEs' mandate is to buy mortgages made to low-income and inner-city homebuyers. If the GSEs were constrained, the burden of making small loans to marginal customers would fall more heavily on banks.
For his part, Greenspan argues that the benefits created by the GSEs simply aren't worth the potential cost of a taxpayer bailout. A recent study by Federal Reserve economist Wayne Passmore concluded that the GSEs probably lower mortgage rates by about 7 basis points—less than one-tenth of 1 percent—and that most of the gains from the financing advantage flow to GSE company shareholders, not to borrowers.
But Greenspan's chief complaint seems to be with the investors who so blithely assume the risk. If markets were truly efficient, investors would surely demand higher interest rates for GSE debt. But the market premium isn't high enough for Greenspan's taste. In his testimony, the one-time Ayn Rand acolyte noted that "despite the explicit statement on the prospectus to GSE debentures that they are not backed by the full faith and credit of the U.S. government, most investors have apparently concluded that during a crisis the federal government will prevent the GSEs from defaulting on their debt." In other words, Greenspan is bemoaning the fact that the buyers of GSE debt—who are among the most sophisticated investors out there—simply aren't cautious enough.Indeed, what seems to bug Greenspan the most about the GSEs is that the investors who buy their debt—a class of people who normally hang on his every word—are ignoring him.