Richard F. Syron's Speech to the Executives' Club of Chicago on December 6, 2005

Prepared Remarks for Richard F. Syron
Chairman and CEO Freddie Mac

The Executives' Club of Chicago
Chicago, IL
December 6, 2005

Thank you, John [Edwardson, Chairman of the Executives' Club of Chicago]. And thank you all for coming out on this balmy December day.

Chicago is widely known as The Windy City. But there's another nickname you've got here that is even more apt for my remarks today: "The City That Works."

I want to talk with you this afternoon about a sector of our economy – housing – that does yeoman work for this country. And about a successful system of housing finance that must itself be allowed to keep working.

I propose to do so by exploring three related subjects.

First is whether there is a housing bubble in America today.

Second is the stabilizing role Freddie Mac plays – whether the risk is a bubble, the Gulf Coast hurricanes we are responding to, or some other crisis facing the housing markets.

Finally, I'll spend a few minutes on the issue of "systemic risk," which has become – in my view, incorrectly – the focus of a great deal of the debate about the Government-Sponsored Enterprises, or GSEs.

That's a lot to cover, so I'll get right to it.

Housing has become an increasingly large and important driver of the U.S. economy. Without its strong influence, for example, the 2001 recession would have been longer and more severe. And the economy would have been notably weaker since then.

Housing consumption and investment has accounted directly for about 20 percent of GDP growth in the past three years. And housing-related sectors have accounted for almost a million of the 3.6 million jobs added. These are our estimates; many others are much higher.

All this raises the stakes for the question, "Are we in a bubble?" Because even a modest downturn in housing would be felt throughout the economy – from construction to banking and real estate to such big employers as Home Depot and Lowe's.

My own view is that we do not have a national house price bubble today. We will see a significant slowdown in housing, but this slowdown is from record levels. Housing starts and home sales will stay strong. Prices will likely rise at rates more in line with long term historical averages, not at the double-digit rates we've seen recently. And a nationwide decline in housing prices remains highly unlikely, based on history and the underlying fundamentals.

It has become clear, however, that there has been a fair amount of froth in certain markets – mostly along both coasts, and in some fast-growing cities in the Sun Belt. In these markets we could see price corrections, especially if economic growth slows. Elsewhere – across large geographic areas of the country including the Midwest and most of the South – incomes have generally kept up with prices and we've seen few signs of overheating.

At this point in the cycle, a "soft landing" that allows incomes to catch up with house prices would be healthy. A crash landing provoked by bad policy decisions and spiking interest rates would not. I believe a soft landing is achievable – but it won't be soft at every airport.

Here in Chicago, sound fundamentals have helped to sustain one of the country's healthier big-city housing markets. Price appreciation for the last five years, on an annualized basis, has nearly matched the national average of 9.2 percent. Even here, however, there has been some softening in high-end neighborhoods.

Fortunately, resiliency is a distinctive strength of housing. For stocks or even bonds, a down year for the markets overall is nothing extraordinary. For housing, it hasn't happened on a nationwide basis in more than 70 years.

But housing is more than a durable form of wealth. It's also our most widely distributed form of wealth. Indeed, for most Americans, the home is their largest asset. Housing gains are also likelier to be spent than, say, stock market gains. And when they are, roughly two thirds of the time this spending is put to work for such purposes as home improvement, education, investment or starting a business.

Freddie Mac has played a vital role in all this, by working to enhance both liquidity and affordability throughout the housing finance system. But it's a third aspect of our GSE mission that is particularly important these days. And that is our work to be a source of stability for housing – as demonstrated in our efforts to respond and rebuild in the wake of Katrina and the other recent hurricanes on the Gulf Coast. For example:

• We are helping affected borrowers – in ways that range from suspending mortgage payments to modifying troubled loans; and we are typically absorbing these costs.

• We are helping lenders – infusing up to $300 million of liquidity into the affected Gulf area.

• We have taken humanitarian steps – committing more than $10 million to hurricane relief efforts and working to provide housing units from our own small inventory.

• Finally, we are helping displaced families on the Gulf Coast – using our retained portfolio to buy up to $1 billion in mortgage revenue bonds, enabling low-cost mortgages and home repair loans for up to 10,000 low- and moderate-income families.

All these steps underscore Freddie Mac's capacity and commitment to help protect America's homeowners, our housing finance system, and the broader economy, from the shock of unexpected events.

But while the recent hurricanes have been extraordinary events, in an important sense, they have not been extraordinary for Freddie Mac. As proof, consider just a few of the many other times we have acted to prevent bad situations from getting worse:

• During the New England credit crunch of the 1980s, I was President of the Boston Fed. And I saw how the GSEs stepped up and supported the conforming residential mortgage markets – even as other sectors, including construction lending and commercial real estate, took a hit.

• In 1998, after the Russian debt crisis and other events, the big banks pulled back from mortgage lending, including the jumbo market. But in the conforming market where we operate, the GSEs stepped in and bought more mortgages, using our retained portfolios. Our monthly volume figures show our increased activity. As a result, the difference between conforming and jumbo interest rates more than doubled. And consumers benefited because we did our job.

• Last but not least, 9/11. After the attacks, the bond markets shut down and no one knew what to do. The GSEs took the lead by issuing debt, providing a mortgage bid, and helping the mortgage markets keep on going. So the housing sector was remarkably unaffected – and it went on soon to become the engine of the economic recovery.

In short, responding to the devastation on the Gulf Coast is not a one-off for Freddie Mac. This is the kind of thing we are here to do. It's why Congress designed us to be a source of stability, liquidity and affordability in good times and in times of crisis.

The GSEs also enhance stability routinely – in a more systemic way. We make sure that households do not have to bear the interest-rate risk associated with their mortgages, unless they choose to. This may well be our single most important function – more valuable even than the rates we lower or the stability we provide. Our role is to take this risk from households and to manage and transfer it out into the capital markets, which are better equipped to handle it.

We do this largely by supporting longer-term, fixed rate prepayable mortgages – what I've called "the American Mortgage." As shown by research for the U.K. treasury and by the International Monetary Fund, this kind of lending is good for a nation's economy, making it less prone to boom and bust. It's also good for households.

The American Mortgage is a major national advantage. Its broad availability in this country is almost unique in the world. The key reason is the GSEs.

Even in Canada, a country so close and similar to ours, consumers face very different choices. You can be in Detroit and call mortgage brokers just a few hundred yards away in Windsor, Ontario. The typical fixed-rate mortgage you'll find is only seven years long; requires 25 percent down; and imposes a stiff penalty for refinancing.

The many benefits of the American Mortgage are not free, however. The risk has to go somewhere. By having the GSEs manage and disperse a good share of the risk, the U.S. incurs less systemic risk than by putting the mortgages solely in bank portfolios.

Some of the reasons are technical. But let me at least begin to demystify "systemic risk" in more straightforward terms.

For the past several years, the debate in Congress about GSE regulatory reform has rightly focused on the most effective oversight structure, the regulator's discretion over capital, and so forth. But while the GSEs were effective, they were also arrogant. So as time went by, this debate became seen, by some, as a perfect opportunity to cut the GSEs down to size. The chosen vehicle has been the notion of "systemic risk" – the claim that the GSEs pose a looming threat to the nation's housing finance system, indeed to our financial system as a whole.

The proposed solution? Shrink the GSEs and you eliminate systemic risk.

Well, competitive issues are at work here. And unfortunately, the truth is not nearly so convenient. The risks inherent in mortgage lending are real. And they don't disappear so easily.

American homeowners typically can and do prepay their mortgage any time they like. But this great option for consumers is also a great uncertainty for mortgage investors.

Because mortgage risks are inherent in our system, you can't eliminate them just by forcing the GSEs to sell all their mortgages. All you do is shift them to someone else's balance sheet. And these days, that "someone else" is very likely to be one of the nation's largest banks.

Unfortunately for Chicago, not a single one of those banks is local. Not even close. And that's a sea change.

At the end of 1999, the largest Chicago bank was Number 4, and the biggest in the nation was just three times larger. But the banking industry has seen massive consolidation and growth. Today, here in America's Second City, the largest Chicago bank is Number 34 in the nation – and the biggest bank is more than 30 times its size.

Already, 40 percent of all U.S. banks' mortgage-backed securities are owned by just three big banks.

With that kind of increasing concentration in banking, if the GSEs are forced to sell off our mortgage holdings, it's likely these mortgages will end up on the balance sheets of the nation's largest banks. And so the risk associated with mortgage investing will be shifted – but it will not be reduced.

In fact, systemic risk may well actually be increased.

That's because America has the advantage of relying on not just one, but two models to finance mortgages. One is the insured depositories model – banks and thrifts. The other is the capital markets model, which operates through the GSEs, together with a network of mortgage originators and capital market investors.

In this more diversified, dual system of ours, banks and GSEs compete for mortgage assets. This spirited competition brings down mortgages rates for borrowers. America's dual system also ensures that mortgage money is always available.

Today, everyone still wants to sell you a mortgage. But it won't always be this way. A couple of bad years in mortgage lending, or a slowdown in house price appreciation, and banks will quickly turn to greener pastures. It's the GSEs that have a congressional mandate to stay in housing and make sure that mortgage money is plentiful. Shrink the GSEs and this "backstop" source of liquidity is put at risk.

With the GSEs diminished, all but the biggest banks will have a tougher time competing. This is because the GSEs are the major liquidity provider to the nation's regional and community banks – like those here in Chicago. With us in the market, such banks have a choice of whom they want to sell their mortgages to. The added competition is good for smaller banks – and for the consumers, communities and cities they serve.

We've tried the one-model system before, in which depository institutions with an explicit federal guarantee fund the majority of fixed-rate mortgages. The unhappy result was the Thrift Crisis. There, you had plenty of apparent diversification – thousands of Savings & Loans – but they all faced the same interest rate risks and inherently bet the same way.

Today, we have a better system, with our eggs spread in two baskets: the bank model and the GSE model of housing finance. This dual, competing system has a proven track record of success. We should let it keep working.

I'd be the first to agree that the GSEs grew at an unsustainable pace in the late 1990s. In that time of great market turbulence, as I noted, our increasing activity helped keep the cost of conforming mortgages low compared to the spike in jumbo mortgage rates.

Today things are very, very different. First, competition for mortgages is fierce, and not just from banks and thrifts. Now, relatively new players like private label issuers and hedge funds are vying for conforming mortgage assets.

Second, there is better information. More institutions have the better prepayment models and information needed to deal with mortgage risks.

The result is that market forces are working quite well, and the GSEs' growth has slowed dramatically. Since the beginning of 2000, total mortgage debt outstanding has grown by 80 percent. The retained mortgage portfolios of Freddie Mac and Fannie Mae together have grown by 75 percent. By contrast, the portfolios represented by the five largest banks and thrifts have grown by 132 percent.

However, the fact that we could step in and buy mortgages as needed provides a critical financial and psychological backstop to the entire market. And should market demand for mortgages begin to wane, we are always there to provide liquidity and keep costs low for consumers.

Sacrificing the GSEs' ability to purchase mortgages and issue debt will only weaken housing and the broader economy. It will destroy our housing finance system's equivalent of a "Strategic Petroleum Reserve" for when times get tough. And to solve yesterday's hypothetical problem, it will cause tomorrow's very real unintended consequences.

You've been very attentive. So let me wrap up.

This is a delicate and uncertain time, both for housing and our broader economy. The Gulf hurricanes heightened this – adding inflationary pressures, job losses, housing needs, you name it. We're also facing hard challenges on a number of other fronts.

On top of all that, we've seen a number of signs that the housing markets at last may have crested. And with rates on all mortgages rising by half a percent or more since this summer, it's little wonder.

At a time like this, where our nation has some solid sources of stability, the last thing we want to do is kick a leg out from under the stool. To the contrary, if ever the country needed the GSEs to do all we can and provide a steadying influence, now is that time.

Does Freddie Mac want strong oversight? You bet. Let's have a strong regulator and reinforce market confidence, with accounting beyond reproach. But this is the worst possible moment to make the GSEs play permanently with both hands tied behind our backs.

Congress and the president got it right in 1970 when they set up a secondary market, with two competing GSEs, that attract private capital to serve a public mission. For more than three decades now, the results have been clear: it's working.

That's why, at the end of the day, I have faith in the wisdom of our political system to do the right thing for America's families and our nation. So we can keep on being a force for stability and opportunity…as part of the finest housing finance system in the world.

Thank you very much. I'm happy to take your questions.