Chapter 5

Charter Repeal Would Increase Taxpayer Risk

Some advocates for charter repeal seem to view Freddie Mac and Fannie Mae as isolated institutions that can be significantly modified without imposing a negative impact on the entire housing finance system. They also tend to assume that the government plays little or no role in the rest of the system. In fact, the government’s role in housing finance is pervasive. The vast majority of mortgage originations and outstanding mortgage debt benefits in some way from the government’s involvement in mortgage markets. Repealing the charters would not eliminate the government’s role or risk; in fact, it likely would increase it. Moreover, it would have dramatic repercussions for the housing finance system.

A. Government’s Commitment to Housing Is Multifaceted

The idea that the vast housing finance system operates largely without government support is an illusion. From federally insured mortgages to federally insured deposits to FHLB advances, the present system represents a complex array of government involvement. The government’s role in housing finance, including the chartering of Freddie Mac and Fannie Mae, reflects two underlying beliefs: that housing is important to America’s well-being and that the government has an important role to play in maintaining a stable and efficient housing finance system.

Although government influence varies (by, for example, the type and degree of government ties), a pattern of support emerges across the spectrum of institutions involved in the provision of housing finance (Exhibit 13). At one end are government agencies, which insure or guarantee 15 percent of the single-family mortgage debt outstanding. At the other extreme are private individuals, holding 5 percent of the mortgage debt; they may be providing financing when they sell their homes or providing financial assistance to relatives. In between are state and local governments, with their housing finance agencies, federally insured depositories, the FHLBs, Freddie Mac and Fannie Mae, and other private companies.

1. Government Agencies

FHA, VA, RHS and Ginnie Mae are the government agencies directly involved in supporting housing finance. .1 FHA fully insures low-down-payment, smaller-balance mortgages financing moderately priced homes. VA guarantees loans with as little as zero down payment for active-duty and retired military employees and reservists. RHS operates both an insurance and a guarantee program for loans with LTV ratios up to 100 percent, primarily in rural areas. Ginnie Mae provides a secondary market for FHA, VA and RHS loans by guaranteeing pools containing these loans; conventional loans are not permitted in Ginnie Mae mortgage-backed securities.

State and local governments also may operate programs to insure or guarantee single-family mortgage loans, often through a housing finance agency. Together these federal, state and local government agencies accounted for $0.6 trillion or 16 percent of mortgage debt at the end of 1995.

2. Depositories

Depository institutions, including commercial banks and thrifts, also benefit from government involvement. The full faith and credit of the federal government supports these institutions by explicitly guaranteeing deposits up to $100,000 and implicitly guaranteeing deposits above that amount. These guarantees allow institutions to attract deposits to fund their operations, including the origination and investment in mortgages, even when they may be in deep financial trouble. In exchange, depositories have been required to pay deposit insurance premiums into the Bank Insurance Fund, the Savings Association Insurance Fund or the National Credit Union Share Insurance Fund. Regulators recently determined that the bank fund was adequately capitalized and reduced insurance premiums to zero for well-managed, well-capitalized banks..2 Thus, many commercial banks currently pay only a fixed annual fee of $2,000 for explicit government insurance for all insured deposits.

In contrast to Freddie Mac and Fannie Mae, which are restricted to residential mortgages, depositories may engage in a number of financial activities. At any time, they may change their level of participation in the housing finance system or exit the system completely. Only savings institutions have incentives to remain active in housing finance..3

To a great extent, depositories tend to hold mortgages, particularly ARMs, that they have originated. They also may purchase Freddie Mac, Fannie Mae or private-label mortgage-backed securities for their investment portfolios. These investments are typically funded by deposits, FHLB advances or other borrowings. As of the end of 1995, the single-family mortgage debt held by federally insured depositories (net of any FHA loans, VA loans or Ginnie Mae securities but including holdings of other mortgage-backed securities) totaled $1.6 trillion or 43 percent of outstanding debt.

3. Federal Home Loan Banks

Operating as a system within a system, the FHLBs--holding $34 billion or 1 percent of mortgage debt in securitized form--represent the next level of government support. Chartered by Congress in 1932, the FHLB system is composed of 12 district banks that make low-cost loans, or advances, to member institutions. Typically collateralized by mortgages, the advances help finance the portfolios of depositories and other members of the FHLB system. Because FHLBs pay no federal or state income tax and issue debt at favorable rates, FHLB members enjoy low-cost funds--providing a second level of government support to many depositories. Although they lack an explicit government guarantee, the FHLBs hold little independent capital. Instead, they are capitalized by member purchases of FHLB stock redeemable at the member’s option. A 1993 CBO study warned that the FHLB capital would not protect the government from significant losses..4

4. Freddie Mac and Fannie Mae

Unlike depositories, Freddie Mac and Fannie Mae do not enjoy the full-faith-and-credit guarantee of the government. The benefits Freddie Mac and Fannie Mae provide consumers come at no cost--and essentially no risk--to the government or to taxpayers. Unlike the FHLBs, the companies operate with private shareholder capital.

Freddie Mac and Fannie Mae have statutory affordable housing goals and are subject to government oversight of their safety and soundness. At the end of 1995, Freddie Mac and Fannie Mae were financing about $0.9 trillion or 24 percent of single-family mortgage debt..5

5. Other Institutions

Among the few firms operating in the housing finance system with a lower level of government involvement than Freddie Mac or Fannie Mae are private mortgage insurers and independently owned mortgage companies.

Mortgage Insurers: In the government market, FHA, VA and RHS protect mortgage holders against default. In the conventional market, this function is filled by private mortgage insurers. By charter, Freddie Mac and Fannie Mae may not purchase mortgages with LTV ratios greater than 80 percent unless the mortgages carry insurance or some other form of credit enhancement. By providing insurance, mortgage insurers reduce losses for Freddie Mac and Fannie Mae in the event of loan foreclosure. Mortgage insurers’ operations are regulated under state law, but federal regulation is generally minor.

Mortgage Companies: In contrast to mortgage companies that are subsidiaries of federally insured depositories are independently owned mortgage companies. The activities of these firms vary; some are primarily retail lenders operating in the primary market, while others, especially larger mortgage companies, may also or exclusively engage in secondary market wholesale activities. Mortgage wholesalers do not deal directly with consumers; rather, they buy mortgages from different lenders for eventual securitization and sale.

Unlike Freddie Mac and Fannie Mae, these companies have no statutory goals to serve the low- or moderate-income segment of the market; they are free to enter or exit the housing finance system at will. Although mortgage companies operate without government backing, they generally originate and service large loan portfolios that are backed to varying degrees by the government or by government-chartered corporations.

The recent history of mortgage originations by institution type shows the pervasive government support for primary market originations (Exhibit 14). Combining the government-insured or guaranteed market (FHA, VA and RHS), depository activity (including originations by their mortgage company subsidiaries and jumbo mortgages originated by independent mortgage companies and sold to depositories), and the conforming mortgages originated by independent mortgage companies and salable to Freddie Mac and Fannie Mae reveals an enormous level of government support. Only the sliver of the market represented by originations of jumbo mortgages by independent mortgage companies--about 6 percent of 1994 lending--can be considered nongovernmental..6 Because these originators use Freddie Mac and Fannie Mae securities as hedging instruments and benefit from standardization and innovations that the companies bring to the market, even this segment of the market indirectly benefits from government-sponsored activities. It is fair to say that to some extent the government’s support touches all home mortgage lending in the country.

B. Market-Driven Incentives Make the System Fiercely Competitive

Every day, Freddie Mac and Fannie Mae compete intensely with each other and with depositories, private conduits and other investors for mortgage investments. The market share of any of these participants can change dramatically depending on market conditions, regulatory constraints and institutional factors. The intense competition has benefited borrowers. A recent study concluded that “the fierce competition that has developed in the mortgage market has driven down the costs of origination and servicing, in part by stimulating the adoption of cost-saving technology.”.7

Depending on business and economic conditions, the share of mortgage originations sold to the secondary market can vary widely. (Exhibit 15) shows that particularly dramatic swings have occurred quite recently. When mortgage interest rates plummeted two full percentage points in 1993, borrowers flocked to refinance their mortgages, primarily with fixed-rate mortgages. Because Freddie Mac and Fannie Mae can quickly expand the supply of funds for fixed-rate mortgages, this surge in demand caused Freddie Mac’s and Fannie Mae’s combined purchase share to soar to more than 60 percent and the depository share to sink to 28 percent. By early 1995, however, the market had reversed. Rising mortgage rates and aggressive ARM pricing on the part of depositories had drawn borrowers back to the ARM market. Largely funded with short-term liabilities, depositories aggressively compete for ARMs to mitigate interest-rate risk. In the first quarter of 1995, the share of originations purchased by Freddie Mac and Fannie Mae plummeted to about 23 percent, and the share held by depositories and other investors rose to 73 percent. These recent dramatic changes in market share reveal the ultimate flexibility of the current housing finance system to respond to abrupt changes in economic conditions, borrower loan preferences and overall mortgage demand.

C. Charter Repeal Would Increase Federal Liability and Responsibility

In the event of charter repeal, many capital market investors that hold Freddie Mac and Fannie Mae securities would reduce their presence while others would completely exit mortgage markets. In their wake, government agencies and federally insured depositories--with their full faith and credit guarantees--would assume noticeably larger roles. As a result, taxpayers would directly shoulder a larger share of single-family mortgage debt than they do today.

In terms of conventional lending, the post-repeal system would feature higher mortgage rates and reduced availability of low-down-payment loans. The government programs--FHA, VA and RHS--and their secondary market facility Ginnie Mae would be largely immune from these negative repercussions. Relatively lower rates on government mortgage products and continued availability of low-down-payment loans would pull many families away from the conventional market and attract them to the government market. As a result, lending activity by FHA, VA and RHS, and Ginnie Mae pool guarantee volume, would increase.8

In 1994, more than 70 percent of conventional conforming borrowers obtained loans that would have been eligible for the FHA program..9 If all of these conventional borrowers had selected FHA-insured mortgages, the combined share of FHA and VA loans would have risen from about 19 percent of the total market to as much as one-half, or from 1994’s $143 billion in mortgage originations to about $380 billion. This increase in lending would result in significantly greater liability for taxpayers than exists today.

Depository institutions, which dominated the 1970’s conventional market and today’s jumbo market, also would play a far larger role in a post-repeal system. Because of their full-faith-and-credit deposit insurance, a significant increase in depository lending would put more taxpayer dollars at risk.

As depositories increased their role in the housing finance system, the FHLBs would be called upon to increase their advances to depositories. Because FHLBs have little independent capital, increased advances would expose taxpayers further.

America’s vast housing finance system is critical to both the economy and individual homeowners. Because the housing finance system is just that--a system--the removal of Freddie Mac’s and Fannie Mae’s charters would reverberate throughout. Moreover, charter repeal would not eliminate the government’s extensive role in mortgage markets. In fact, charter repeal would tend to increase government involvement, thereby increasing taxpayer risk, as federally insured depositories, FHA and VA played larger roles. The next chapters analyze other effects of repealing the charters.

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