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 Chapter 4
Freddie Mac Benefits the Public at No Public Cost
In ensuring a steady flow of low-cost mortgages, Freddie Mac provides important public benefits at no public cost. Homeowners receive $10 billion in reduced mortgage interest costs each year, yet taxpayers do not pay a penny for the activities or the regulation of Freddie Mac and Fannie Mae.
Taxpayers also are protected from risk. As a result of prudent risk management, a focused charter limiting our activities, national diversification, shareholder capital and the high-quality collateral behind the mortgages--American homes--the risk of Freddie Mac defaulting on its obligations is extremely remote.
To ensure the continued vitality of the secondary mortgage market, Congress in 1992 created a set of rigorous and dynamic capital requirements and an independent safety and soundness regulator for Freddie Mac and Fannie Mae. The new regulatory structure--combined with substantial private capital--essentially eliminates taxpayer exposure. A. Freddie Mac and Fannie Mae Receive No Taxpayer Funds
The business operations of Freddie Mac and Fannie Mae are entirely self-sufficient. Because capital is provided by private shareholders, neither corporation has ever received taxpayer dollars. In addition, Freddie Mac and Fannie Mae pay all the costs associated with their own safety and soundness regulator. Congress assessed Freddie Mac and Fannie Mae for OFHEO’s initial costs and authorized OFHEO to assess the corporations for its ongoing operating expenses. Since 1993, Freddie Mac and Fannie Mae combined have paid $30 million in regulatory costs. B. Freddie Mac and Fannie Mae Pay Substantial Federal Taxes
As successful Fortune 500 businesses, Freddie Mac and Fannie Mae pay large amounts of federal income tax. In 1995, their combined federal tax payments exceeded $1.3 billion. Over the past five years, Freddie Mac and Fannie Mae both paid federal income taxes at an average effective rate of 31 percent 1, similar to the rate for banks, thrifts and other financial firms. In contrast, the FHLBs pay no federal income taxes at all. C. U.S. Treasury Not Legally Obligated to Support Either Company
In 1992, the federal government expressly disavowed any direct or indirect obligation to support Freddie Mac and Fannie Mae or to guarantee the securities and obligations issued by them.2 In addition, the U.S. Supreme Court has stated that such statutory disclaimers of liability are legally enforceable.3 Without the benefit of government guarantees, any losses incurred by Freddie Mac and Fannie Mae would be borne first by shareholders and then by other creditors. D. Government Studies Show Taxpayer Risk Is Minimal
Critical to the safe operation of the two institutions is an adequate supply of shareholder capital. Like other businesses, Freddie Mac and Fannie Mae hold capital against the risk of loss. In the wake of mounting losses in the thrift industry during the 1980s, Congress was determined to eliminate any chance of a similar collapse in the secondary mortgage market. Consequently, Congress in the late 1980s and early 1990s directed several government agencies to study the adequacy of Freddie Mac’s and Fannie Mae’s capital. The findings of these studies are summarized below:
Department of the Treasury: Following a detailed analysis of the operations of the two secondary market companies, Treasury concluded in 1990 that the current operating risks did not “present an imminent threat to the Federal Government.” 4 One year later, Treasury reaffirmed its conclusion following an independent rating-agency assessment of Freddie Mac’s and Fannie Mae’s safety and soundness.5 Without taking into consideration Freddie Mac’s charter, Freddie Mac received an A+ rating. To buttress financial strength, Treasury recommended the application for each corporation of “an appropriate capital standard” that would both “ensure an adequate capital buffer against adverse economic conditions and provide management incentives to manage prudently the risks the corporation undertakes.”6
Office of Management and Budget (OMB): OMB tested Freddie Mac’s and Fannie Mae’s capital adequacy by subjecting their business activities to a ten-year stress test that simulated the financial and economic conditions of the Great Depression. The test showed that if a depression lasted ten years, given 1990 levels of capital, both Freddie Mac and Fannie Mae had sufficient capital to survive. This led OMB to conclude that in the event of a severe nationwide economic downturn, the probability of either Freddie Mac or Fannie Mae defaulting would be “close to zero.”7
Congressional Budget Office (CBO): Conducting its own assessment of the risks posed by Freddie Mac and Fannie Mae, CBO stated that the two institutions “are relatively well capitalized with respect to, and subject the government to a low level of risk of loss from, their exposure to credit risk and interest rate risk, and appear to be well managed and to operate efficiently.”8 Based on the findings of the several studies, Congress concluded in 1992 that Freddie Mac and Fannie Mae “currently pose low financial risk of insolvency.”9 Since then, Freddie Mac and Fannie Mae have increased their capital significantly, further reducing risk. Exhibit 12 contrasts the growth in stockholder equity and mortgage portfolios for the two corporations. From 1992 through 1995, Freddie Mac’s capital base grew 128 percent while our mortgage portfolio increased 47 percent. Today, Freddie Mac and Fannie Mae have significantly more capital than the level considered adequate by Treasury, OMB and CBO several years ago.
E. Safety and Soundness Built into Charters
Safeguards against possible default on the part of Freddie Mac and Fannie Mae are embedded in the requirements and restrictions contained in their congressional charters.
First, by limiting Freddie Mac and Fannie Mae to the residential mortgage market, Congress has ensured that high-quality collateral--American homes--stands as a buffer between the two companies and the taxpayers. Of the different types of real estate--residential, commercial and farm--residential real estate is the least risky because most properties are owned by homeowners. In contrast are properties owned by investors who generally have only a financial interest in the property. Noting that single-family mortgage default rates are much lower than defaults on loans for education, agriculture or small businesses, OMB in 1991 concluded that homeowners resist default even when default is in their financial interests.10 Furthermore, in the unlikely event of default, the collateral would reduce the loss substantially below the loan balance.
Second, Freddie Mac and Fannie Mae are restricted by charter to purchasing only certain types of mortgages. They may not purchase loans with LTV ratios exceeding 80 percent, that is, mortgages with down payments less than 20 percent, unless private mortgage insurance coverage (or other forms of credit enhancement) is provided to minimize their risk of loss. 11 As of the end of 1995, the original LTV ratio of mortgages guaranteed by Freddie Mac averaged 72 percent; after accounting for loan amortization and property appreciation, the estimated average “current” LTV ratio of these mortgages was 64 percent. Thus, more than one-third of the value of Freddie Mac loans is held by borrowers in the form of equity in their homes. This is the first line of defense against losses.
Third, the national scope envisioned by the congressional charters also plays an important role in minimizing risk. Because Freddie Mac and Fannie Mae purchase mortgages from all over the country, downturns in one region are offset by strong performance in others. As a result, the companies need less capital to secure their mortgage portfolios. An analysis of the performance of 300,000 Freddie Mac mortgage purchases showed that if the loans had been collateralized by properties located in only one of five geographic regions, Freddie Mac would have needed two to three times as much capital to satisfy a capital standard incorporating a risk-based capital stress test.12 Thus, not only is a nationwide secondary market essential to maintaining an uninterrupted flow of low-cost mortgages; a national market also diversifies risk, further protecting the companies from insolvency.
One critic has charged that as guarantors of $1.3 trillion in mortgage debt, Freddie Mac and Fannie Mae pose an enormous contingent liability to the federal government.13 A stark exaggeration, this argument can be dismissed on several grounds. The risk associated with the mortgage debt guaranteed by the two companies is offset by the $2 trillion in American homes that secure the mortgages. Taxpayer risk also is offset by national diversification, private mortgage insurance or other forms of credit enhancement on higher-risk mortgages and shareholder capital. To suggest the existence of a $1.3 trillion contingent liability is to suggest that 17 million homeowners would default at once on their mortgages, that house values in 50 states would plummet to zero, that mortgage insurers would be incapable of covering losses and that Freddie Mac and Fannie Mae would deplete their capital and loan-loss reserves.
Moreover, the criticism ignores the government studies stating that Freddie Mac and Fannie Mae pose minimal risk and their subsequent large increases in capital. It also overlooks the stringent capital requirements and early warning systems built into the safety and soundness regulation adopted by Congress in 1992, including periodic examinations, requirements for frequent reports and forward-looking capital requirements.
Finally, this criticism ignores the government’s express disavowal of any obligation to support either company. This disavowal is prominently displayed on all securities issued by Freddie Mac and Fannie Mae. F. New Capital Requirements: The Industry’s Toughest
In 1992, Congress concluded that Freddie Mac and Fannie Mae posed low financial risk of insolvency. To ensure that future homebuyers have access to a stable supply of low-cost mortgages without putting taxpayers at risk, Congress installed permanent regulatory structures to safeguard the safety and soundness of both Freddie Mac and Fannie Mae. Far from tampering with their core business operations or attempting to substitute political judgments for business acumen, Congress sought to affirm and strengthen the existing housing finance system. 14
The new capital standards incorporate traditional and risk-based measures. At the base is a minimum capital requirement that resembles a traditional bank and thrift leverage requirement for on-balance sheet assets. Unlike bank and thrift requirements, however, Freddie Mac and Fannie Mae also must hold capital for their off-balance sheet assets. In addition to this minimum leverage requirement is an innovative risk-based standard that considers extremely severe interest-rate and credit-risk conditions, such as those experienced during the Great Depression. Congress specifically required that Freddie Mac and Fannie Mae hold enough capital to survive a ten-year period in which credit losses equal, on a nationwide basis, the worst actual two-year regional experience. In addition, capital must be sufficient to survive an interest-rate shock greater than any previously encountered by Freddie Mac and Fannie Mae. 15 Finally, to mitigate management and operations risk, the companies must hold an additional 30 percent of the capital needed to survive the stress test, an unparalleled requirement unique to Freddie Mac and Fannie Mae.
The risk-based capital standard is the most stringent capital test in the financial services industry. Imagine a hypothetical depository institution holding 30-year fixed-rate mortgages funded with one-year certificates of deposit. If it were subject to the risk-based capital standard Congress established for Freddie Mac and Fannie Mae, the capital requirement could easily be 30 percent. 16 Contrast this with the 4 percent capital requirement depositories actually face for single-family mortgage loans. The use of the stress-test method of determining capital levels would have prevented savings institutions from becoming insolvent between 1979 and 1982 due to changes in interest rates.
The risk-based capital standard applied to Freddie Mac and Fannie Mae supersedes all other capital standards in terms of its ability to measure capital relative to risk. First, it measures capital by projecting the mortgage cash flows for ten years into the future. Unlike traditional measures that are based solely on historical book value, by projecting future cash flows, the risk-based measure enables OFHEO to detect whether there are hidden losses (or gains). Therefore, Freddie Mac’s and Fannie Mae’s capital standard provides a truer measure of the resources available to absorb losses.
Second, the risk-based capital standard finely differentiates risk by applying different capital requirements for individual mortgages depending on the coupon, amortization period, LTV ratio and other financial characteristics. This tailors the capital standard to the specific assets in the companies’ portfolios.
Third, the capital standard is dynamic. Unlike traditional leverage ratios, as risks change so does the capital requirement. For example, a mortgage’s credit risk is much greater if house prices have been declining than if they have been rising. Similarly, interest-rate risk on a portfolio of mortgages is likely to change as interest rates change. Because of the dynamic nature of the stress test, as these and other factors change, the required level of capital changes.
Fourth, by incorporating all the assets and liabilities of the company, the capital standard differentiates between risks associated with different financing strategies.
Capital plays a crucial role in the safety of Freddie Mac and Fannie Mae. The larger the capital cushion, the more losses Freddie Mac and Fannie Mae can sustain before net worth falls to zero. The dynamic capital standard creates strong incentives for the two companies to manage risk and also provides advance warning of possible problems.17 Congress and OFHEO can shield the taxpayers from risk by requiring Freddie Mac and Fannie Mae to restore capital to appropriate levels within a specific amount of time or take more drastic actions by restricting their activities or, as a last resort, by appointing a conservator. 18 Thus, the combination of standards that both measure capital in relation to specific risks and enable OFHEO to take prompt corrective action effectively eliminates any risk of insolvency. G. Exclusive Safety and Soundness Regulator
In addition to creating new capital requirements, Congress in 1992 established a safety and soundness regulator for Freddie Mac and Fannie Mae. Unlike other financial regulators concerned with the activities of numerous institutions, OFHEO was given only one job: to ensure that Freddie Mac and Fannie Mae “are adequately capitalized and operating safely.” 19 As a result of this targeted scope, OFHEO is positioned to develop a high degree of regulatory expertise and knowledge concerning the two companies. Working independently within HUD, OFHEO can develop safety and soundness regulations and take enforcement actions without review or approval by the Secretary of HUD.
To enforce the capital requirements, OFHEO is equipped with important examination and enforcement tools. The director of OFHEO may impose civil monetary penalties in specified circumstances and, in particular situations of serious capital deficiency, may place either company into conservatorship. Together these tools protect taxpayers in the unlikely event of a Freddie Mac or Fannie Mae default.
On a quarterly basis, OFHEO evaluates the adequacy of Freddie Mac’s and Fannie Mae’s capital. Since 1993, OFHEO has informed Congress that both Freddie Mac and Fannie Mae are “adequately capitalized,” the highest possible rating. OFHEO continues to develop regulations implementing the risk-based capital requirements. In the meantime, Freddie Mac regularly subjects its operations to its own strenuous risk-based stress test to ensure an adequate capital base. Freddie Mac Brings Substantial Benefits at No Public Cost
Recent government studies have sought to compare the costs and benefits of the activities of Freddie Mac and Fannie Mae. The substantial public benefits that the two companies provide are well documented: lower and less variable mortgage interest rates, greater availability of fixed-rate mortgages without government insurance and a broad investor group to finance housing. Lower mortgage interest rates alone save homeowners $10 billion each year.
The correct way to measure the cost of Freddie Mac’s and Fannie Mae’s activities is in terms of the cost--or potential cost--to the government and taxpayers. The direct cost is zero: Freddie Mac and Fannie Mae receive no taxpayer dollars. Also, the potential cost is near zero: Freddie Mac and Fannie Mae pose essentially no risk of insolvency. Therefore, at practically no public cost, Freddie Mac and Fannie Mae bring substantial public benefits.
Some recent studies have compared the benefits that Freddie Mac and Fannie Mae produce with their lower funding costs. Freddie Mac and Fannie Mae are able to raise funds at attractive rates in both the debt and securities market; that is, investors are willing to purchase Freddie Mac and Fannie Mae securities at lower yields than corporate securities with comparable features. This so-called funding advantage stems from their congressional charters, as well as from the large-scale efficiency of their operations. 20
This funding advantage comes at no cost to the government or taxpayers. It persists even though the government has expressly disavowed in statute any legal obligation to provide any support for either company, and Freddie Mac and Fannie Mae prominently disclose this on all their securities.
In an attempt to determine the size of the funding advantage, CBO and the General Accounting Office(GAO) compared Freddie Mac’s and Fannie Mae’s debt costs to those for a broad group of financial companies--not necessarily those that invest in residential mortgages. They also used unreliable numbers. Credible estimates of the size of the funding advantage relative to other financial corporations as of the end of 1995 range from $1.8 billion to $3.2 billion before taxes and $1.3 billion to $2.3 billion after taxes.21
A more relevant yardstick would compare Freddie Mac’s and Fannie Mae’s cost of funds to that of other significant mortgage investors, primarily depository institutions. Depositories have funding advantages of their own: Their full-faith-and-credit, federally guaranteed deposit insurance and their access to FHLB advances allow them to borrow more cheaply than other financial companies. While it is difficult to measure the funding costs for depositories, their extensive access to lower-cost funds makes it unlikely that Freddie Mac and Fannie Mae have a significant funding advantage relative to depositories.22
Because of the role the companies play in connecting investors with homebuyers, lower yields for investors translate into lower mortgage rates for borrowers. Moreover, through standardization, innovation and efficient operations, Freddie Mac and Fannie Mae reduce mortgage rates further and bring additional value to America’s homeowners, renters and the general public. These benefits flow from the corporations’ time-proven abilities to operate under private-sector discipline using the tools provided in their government charters to serve important public purposes. These benefits have come at no cost--and essentially no risk--to American taxpayers.
Footnotes:  1. Freddie Mac, 1995 Annual Report, p. 34 and 1993 Annual Report, p. 34; Fannie Mae 1995 Annual Report, p. 9 and 1993 Annual Report, p. 25. 2. FHEFSSA Sec. 1302(4) and 1304.3. In Lebron v. National Railroad Passenger Corporation, 1995 U.S. Lexis 909 (1995), the Supreme Court stated that there was “no doubt” that Congress’ disavowal of Amtrak’s government backing deprived Amtrak of the power to incur obligations to pledge the credit of the United States. Id. at p. 28. In the case of Freddie Mac and Fannie Mae, the disclaimer of financial responsibility is much more explicit.4. Treasury Dept., Report of the Secretary of the Treasury on Government-Sponsored Enterprises B-81, A-95 (1990)(1990 Treasury Report).5. Treasury Dept., Report of the Secretary of the Treasury on Government-Sponsored Enterprises 2, 6, A-25-45 (1991).6. 1990 Treasury Report at 14.7. OMB, Budget of the United States Government, Fiscal Year 1992, Part Two-229 (1992). See also CBO, Controlling the Risk of Government-Sponsored Enterprises 172-3, 279-81 (1991). 8. Id. at xxviii. The General Accounting Office conducted two investigations into the risks of Freddie Mac and Fannie Mae in this same time period (Government Sponsored Enterprises: The Government’s Exposure to Risks, GAO/GGD-90-97, August 1990; Government Sponsored Enterprises: A Framework for Limiting the Government’s Exposure to Risks, GAO/GGD-91-90, May 1991). Neither study attempted an aggregate judgment of the overall risks that Fannie Mae and Freddie Mac pose. 9. FHEFSSA Sec. 1302(3).10. OMB, Budget of the United States Government, Fiscal Year 1992 Part Two at 228 (1992).11. Freddie Mac Act Sec. 305(a)(2)..12. CBO, pp. 142-3, citing John M. Quigley and Robert Van Order, “Defaults on Mortgage Obligations and Capital Requirements for U.S. Savings Institutions,” Journal of Public Economics, 44 (1991), pp. 353-69.13. Thomas H. Stanton, “Saying Goodbye When the Job Is Done: The Coming Privatization of Government-Sponsored Enterprises,” The Institute for Policy Innovation, Policy Report No. 133, September 1995, p. 4.14. “Congress created the enterprises under private ownership and management to bring the entrepreneurial skills and judgments of the private sector to bear on accomplishment of public purposes relating to housing. The Committee does not mean to upset this unique structure or to encourage any government official to second guess decisions of enterprise management arrived at through the exercise of honest, unbiased judgment of what is in the best interests of the enterprise.” S. Rep. No. 282, 102d Cong., 2d Sess. 25 (1992).15. The interest-rate risk component of the stress test that Freddie Mac and Fannie Mae must meet requires that the companies have sufficient capital to absorb losses for ten years if interest rates rise by the greater of (1) 600 basis points above the average yield on ten-year constant maturity Treasury bonds during the preceding nine months or (2) 160 percent of the average yield on ten-year constant maturity Treasury bonds during the preceding three years, but in no case to a yield greater than 175 percent of the average yield on ten-year Treasury bonds during the preceding nine months. The interest-rate risk stress test that Freddie Mac and Fannie Mae must meet also requires that the companies hold capital against possible decreases in interest rates of (1) 600 basis points below the average yield on ten-year Treasury bonds during the preceding nine months or (2) 60 percent of the average yield on ten-year Treasury bonds during the preceding nine months, whichever is less, but not against any decrease to a yield less than 50 percent of the average yield on ten-year Treasury bonds during the preceding nine months. Whether the up-rate or down-rate test applies at any given time depends on which one would require Freddie Mac to hold more capital. See FHEFSSA Sec. 1361.16. In this example, the depository with an initial cost of funds of 6 percent originates a 7-percent mortgage. Its cost of funds then rises by the maximum posited by the stress test to about 10 percent and remains there for ten years. The depository would lose 3 percent for ten years or approximately 30 percent of the mortgage. Under the interest-rate risk component of Freddie Mac’s and Fannie Mae’s capital standard, therefore, it would have to hold 30 percent capital. 17. Shareholder capital at risk sharply distinguishes Freddie Mac and Fannie Mae from the Farm Credit Banks and the FHLBs. The capital of those institutions is cooperative capital held in common by the member financial institutions. Because this capital is not publicly traded or subject to effective market discipline, capital losses would hurt the balance sheets of the member institutions, many of which benefit from full faith and credit deposit insurance. Private shareholder discipline is minimal.18. See Lawrence J. White, The S&L Debacle, Oxford University Press: New York, 1991, pp. 232-5, on the importance of early intervention. 19. FHEFSSA Sec. 1313.20. The fact that the companies’ lower cost of funds does not result solely from their charters is confirmed by the experience of Ginnie Mae. The federal ownership of Ginnie Mae and introduction of Ginnie Mae mortgage-backed securities did not immediately reduce mortgage rates on FHA and VA loans. Rather, over time the liquidity of the mortgage-backed securities and the efficiency of securitizing FHA and VA loans led to a 0.6 to 0.7 percentage-point decline in rates on these mortgages relative to Treasury yields. See Deborah G. Black, Kenneth D. Garbade and William L. Silber, “The Impact of the GNMA Pass-Through Program on FHA Mortgage Costs,” Journal of Finance, May 1981, pp. 457-69; and James P. Rothberg, Frank E. Nothaft and Stuart A. Gabriel, “On the Determinants of Yield Spreads Between Mortgage Pass-Through and Treasury Securities,” Journal of Real Estate Finance and Economics, December 1989, pp. 301-15.21. The lower estimates were reported by GAO. “FNMA and FHLMC: Benefits Derived from Federal Ties,” GAO/GGD-96-98R, letter to the Honorable Richard K. Armey, March 25, 1996, Tables 1 and 2. The higher estimates, calculated by Freddie Mac, use a 0.39 percentage point savings on $210 billion of long-term debt, a 0.09 percentage point savings on $208 billion of short-term debt and a 0.23 percentage point savings on $972 billion of mortgage-backed securities outstanding (excluding securities held in portfolio) at year-end 1995. The yield difference between five-year bullet (averaged for A-rated and AA-rated debt) and comparable Freddie Mac and Fannie Mae debt averaged 0.39 percentage points from September 1992 to May 1996, according to the Lehman Brothers Relative Value Database. The yield difference between three-month A1-P1 commercial paper and 90-day discount notes issued by Freddie Mac, adjusted for issuance costs, averaged 0.09 percentage points over the same period; commercial paper rates were obtained from the DRI-McGraw Hill Money Market and Fixed-Income database. The yield difference between private-label mortgage-backed securities and Freddie Mac and Fannie Mae securities provides an overestimate of the lower funding costs of Freddie Mac and Fannie Mae because the differential includes the effects of liquidity and credit quality. Because Freddie Mac’s and Fannie Mae’s mortgage-backed securities are backed by real-property collateral as well as a corporate guarantee, a proxy for the yield difference on mortgage-backed securities net of liquidity and credit quality can be constructed by calculating the yield difference between five-year, AAA-rated bullet debt and comparable Freddie Mac and Fannie Mae debt; this difference averaged 0.23 percentage points from September 1992 to May 1996, according to the Lehman Brothers Relative Value Database.
Alternative estimates of the funding advantage based on comparisons of yields on long-term Freddie Mac and Fannie Mae callable and noncallable debt to yields on other corporations’ debt that includes AAA-rated debt or callable debt will be unreliable because of the small volume of corporate debt issued with these features. In “Housing Enterprises: Potential Impacts of Severing Government Sponsorship” (GAO/GGD-96-120, May 1996), GAO relied on such calculations by Brent W. Ambrose and Arthur Warga (“Implications of Privatization: The Costs to Fannie Mae and Freddie Mac,” in Studies on Privatizing Fannie Mae and Freddie Mac, HUD, May 1996, pp. 169-204) for its upper-bound estimates. Ambrose and Warga themselves caution against the use of these calculations, however. In “Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac” (CBO, May 1996), CBO appears to rely on similarly flawed data for its upper-bound estimates, although the source is not documented.
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