Freddie Mac Supports Macroeconomic Stability

Special Commentary from the Office of the Chief Economist
by Frank E. Nothaft, Freddie Mac's chief economist
April 22, 2005

The activities of Freddie Mac and Fannie Mae make "the American Mortgage" – the long-term, fixed-rate, freely pre-payable conventional mortgage – the mainstay of the housing finance market. Research has demonstrated that this loan product helps to stabilize macroeconomic growth. "The role of mortgage-market access to global capital markets as an automatic stabilizer for the U.S. economy is demonstrated by the strength of the housing sector and its impact in moving the economy out of the 2001 recession," said Professor Susan Wachter before the Senate Committee on Banking, Housing, and Urban Affairs on Feb. 10, 2005.

According to Freddie Mac's charter, one of our purposes is "to provide stability in the secondary market for residential mortgages…" Research has shown that by providing this stability, Freddie Mac also supports a more stable housing sector, and ultimately, a more stable economy – that is, an economy in which recessions are less severe and inflationary expansions mitigated.

The American Mortgage and Economic Stability

The "American Mortgage" – the 30-year, fixed-rate, conventional mortgage without prepayment penalties – is largely unique to the United States. When interest rates decline (as typically occurs during a recession), borrowers can refinance and take advantage of lower interest rates (thus increasing their purchasing power for other goods) and/or take "cash out" of their accumulated home equity, thereby supplementing their consumption ability. Either way, this supports economic activity and reduces the depth of a recession. When interest rates rise, existing borrowers are sheltered from the adverse effects of higher interest rates and mortgage "payment shock;" such shock would increase the likelihood of foreclosure and destabilize downward pressure on home values.

Two recent studies affirmed the beneficial role of fixed-rate mortgages on an overall economy. One study was commissioned by the United Kingdom (U.K.) Treasury and authored by David Miles. The U.K. mortgage market consists of adjustable-rate mortgages (or very short-term balloons), and the government wanted to know whether there was a benefit to greater promotion of long-term, fixed-rate lending. Miles compared empirical studies of house-price volatility across the United States, United Kingdom and the Netherlands (which also has medium- to long-term fixed-rate loans) and found that U.K. house prices were more sensitive to interest-rate movements than in the other two nations. Further, he compared simulations of the effect of different levels of house-price volatility on personal consumption and economic growth within the United Kingdom. He concluded, "…the results suggest that, had house prices followed a less volatile path…the path of consumption would have been less variable, and as a result, macroeconomic volatility would have been lower." (Miles, p. 94.) Thus, Miles was able to establish a link running from more fixed-rate mortgage lending to less house-price volatility to less consumption variability to more macroeconomic stability over time.

The second analysis is from the International Monetary Fund (IMF). IMF researchers compared house-price volatility over the period 1971-2003 with the proportion of fixed-rate lending in 18 developed countries. The IMF study found that those countries with more fixed-rate lending also had lower house-price volatility (Exhibit 1). The IMF also commented on the linkage running from house prices through consumption spending. "House prices and economic activity are tightly linked. Changes in house prices influence demand and output by affecting households' wealth and capacity to borrow." (pp. 77-78.)

Exhibit 1: House Price Volatility and Fixed-Rate Mortgages

In addition to providing the funding support to the "American Mortgage," Freddie Mac and Fannie Mae also provide stability to the housing sector by providing funds counter-cyclically to lenders. That means that, at the point in the business cycle when economic activity is contracting, Freddie Mac and Fannie Mae increase their relative provision of funds to the mortgage market, and vice versa. In contrast, other mortgage investors (mostly commercial banks and savings institutions) make credit available pro-cyclically, that is, fewer funds are available during a recession. By acting counter to the business cycle, Freddie Mac and Fannie Mae reduce the depth of a housing recession and support credit flows during an expansion on an "as needed" basis.

Two scholars, Joe Peek and James Wilcox, examined residential credit flows relative to potential gross domestic product (potential GDP – an estimate of the economy' s output at full employment) over recessions and credit crunches. They found that Freddie Mac and Fannie Mae provided funds to residential lenders counter to these credit cycles, in stark contrast to the pro-cyclic pattern of bank and savings institutions. Exhibit 2 summarizes their findings by illustrating the change in residential debt-to-potential GDP for the overall residential mortgage market (orange), the change in total mortgage holdings of Freddie Mac and Fannie Mae-to-potential GDP (blue) and the change in mortgage holdings of all other groups (primarily banks and savings institutions)-to-potential GDP (gray). Bars pointing up (positive flows) reflect flows that operate counter to the business cycle, while bars pointing downward (negative flows) mean that credit flows decline during a recessionary period (that is, are pro-cyclic).

The 1960s saw a mid-decade credit crunch and a recession at the end of the decade. Both occurred before Freddie Mac was created and at a time when Fannie Mae was authorized to purchase only Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans. Even during those two cycles, while the residential mortgage market contracted, Fannie Mae was able to partly offset the negative flows through its support of the FHA and VA markets. During the four recessions between 1970 and 2000, Freddie Mac and Fannie Mae increased their counter-cyclic role by increasing their purchase activities during recessions. During the most recent 2001 recession, Freddie Mac and Fannie Mae's purchases more than offset the reduction of credit flows from banks and savings institutions, helping to mitigate the effects of the recession on the overall economy. Freddie Mac and Fannie Mae's activity in the secondary mortgage market had served as an "automatic stabilizer."

Exhibit 2: Freddie Mac and Fannie Mac Mitigate Recessions by Providing Counter-cyclic Credit

References

International Monetary Fund, World Economic Outlook: The Global Demographic Transition, Chapter II, "Three Current Policy Issues," September 2004.

Miles, David. "The U.K. Mortgage Market: Taking a Longer Term View (Part II)," Report for H.M. Treasury, January 2004.

Peek, Joe and James A. Wilcox."Secondary Mortgage Markets, GSEs, and the Changing Cyclicality of Mortgage Flows," ed. Andrew H. Chen, Research in Finance Volume 20, pp. 61-80, 2003.