The Housing Bull that Debt Built

by Dan Denning

Each year the Bush White House produces a budget, it also produces a report called “Analytical Perspectives, Budget of the United States Government.” As the title suggests, it’s a real page-turner. But if you’re patient and you look hard, you will come across some gems.

In this year’s version, I found an entire section on Fannie Mae and Freddie Mac, the Government Sponsored Enterprises (GSEs.) The risks section was especially interesting. Below I’ve cut a snippet from that section and emphasized certain passages.

The Washington Post reported that the Bush administration may and try to limit the growth of GSE assets. Practically speaking, the new regulation would limit the amount of mortgages the GSEs add to their balance sheets. And practically speaking, this would make the market for new mortgage credit tighter, conceivably leading to slower home price growth (and many other darker consequences.)

It’s clear the Bush folks are taking the GSE problem seriously. It’s not clear they can do much about it. Here’s what the report had to say…

“The risks undertaken by the GSEs, if not properly managed, may pose a threat to their solvency. Under some circumstances, they also may threaten the stability or solvency of other financial institutions and the economy. Current Federal law explicitly exempts the securities of the GSEs from the statutory limitation on commercial banks investment in the ”investment securities” of individual firms.

In a February 2003 study conducted by OFHEO utilizing FDIC data, over 2,000 commercial banks held at least 51 percent of their capital in the form of debt issued by Fannie Mae; and almost 1,000 commercial banks held at least 51 percent of their capital in the form of debt issued by Freddie Mac. Should a financial crisis affecting the GSEs and other financial actors develop, the market’s misperception of government backing of GSE securities could affect its course and resolution.

A September 2004 Federal Reserve Bank of Atlanta study indicated concern that severe stress to one of the GSEs might contribute to weakness in other financial institutions that hold significant GSE obligations, especially if the path to resolution of the crisis and the potential for Government intervention are misunderstood.

The potential for systemic risk arising from the GSEs’ size and their central role in mortgage markets combined with the difficulty of managing the risks inherent in a large mortgage portfolio raise fundamental questions about the value they add through their support for mortgage lending and reduced costs to borrowers relative to the risks their current operations pose.

Some research by Federal Reserve economists suggests that GSE securitization activities have a relatively small effect on mortgage interest rates- just a few dollars a month on an average mortgage- and that their practice of holding mortgages in portfolio has almost no effect on mortgage costs.

Instead of being leaders in increasing historically underserved groups’ access to credit, the GSEs have actually trailed the market averages in a number of dimensions. The Administration has sought to narrow the gap by lessening the risks posed by the GSEs and increasing the benefits they offer to the public.