Monday, February 5, 2001

The latest projections from the Congressional Budget Office now show even larger budget surpluses than previously estimated. According to the CBO, there will be $3.12 trillion in surpluses over the next decade in addition to that attributable to the Social Security Trust Fund $1 trillion more than it estimated just last July. As a result, the national debt effectively will be paid off by 2006, under current tax and spending projections.

It is important to remember, however, that the national debt is only one part of the federal government’s indebtedness. Just as individuals may have home mortgages, home equity loans, auto loans, credits cards and other forms of debt, so too the federal government has many other forms of debt in addition to the Treasury bonds, bills and notes that constitute the national debt. Only this last part of the federal government’s total debt is even declining; other forms are exploding.

One of the most rapidly growing elements of the federal government’s debt comes from two agencies known as Fannie Mae and Freddie Mac. These are nicknames. The former is known officially as the Federal National Mortgage Association, and the latter as the Federal Home Loan Mortgage Corp. They both essentially do the same thing, which is to buy mortgages from private lenders. This creates liquidity in the mortgage market and makes it easier for home buyers to get mortgages.

Fannie Mae and Freddie Mac, together with other agencies involved with student loans and farm loans, are known as Government Sponsored Enterprises. That is, they are basically businesses, just like those in the private sector, that are owned by the government. Indeed, GSE’s compete against private companies that do exactly the same thing. However, GSE’s have an unfair advantage because they pay no taxes and have implicit or explicit guarantees for their debts.

When the federal government first got into the business of creating a secondary market for mortgages in the 1930s, it served a useful purpose. Financial markets were not as integrated as they are now, and it was difficult for people living outside major banking centers, such as New York and Chicago, to get mortgage loans, no matter how good their credit. Making it possible for banks to sell their mortgages allowed them to obtain funds to make new mortgages to people who might not otherwise have been able to get one.

Today, of course, financial markets are vastly larger and more sophisticated. There is no longer any need for government agencies to make markets for mortgages. Private financial institutions routinely bundle, package and securitize huge blocks of mortgages, reselling them to insurance companies, pension funds and other investors. As a consequence, Freddie and Fannie are losing their basic justification for existence.

Yet, at the very time that the need for them is falling, Fannie Mae and Freddie Mac are growing out of control. Lending by these agencies has exploded at the very time the national debt is declining. As a consequence, the federal government’s total debt continues to rise.

Since 1997, new securities issued by federal agencies have more than doubled. According to the Federal Reserve, lending by Fannie Mae, Freddie Mac and other GSEs has risen from $213 billion in 1997 to $592 billion in 1999. Complete data for 2000 are not yet available, but in the third quarter agency lending was $502 billion annually. As a consequence, the total indebtedness of these federal agencies has risen from $2.8 trillion in 1997 to $4.2 trillion at the end of September.

To put these numbers in context, it is worth noting that new issues of Treasury securities, generally known as the national debt, have fallen dramatically over the same period. In 1996, the Treasury borrowed $147 billion from the public. By 1998, it was no longer borrowing any net funds at all and was paying off the debt. That year, $55 billion of the debt was paid down and in 1999 another $71 billion was extinguished. In the first three quarters of last year, an amazing $282 billion of Treasury securities were withdrawn from the market, meaning this much money was added to financial markets by the Treasury.

Thus we see that between 1997 and 2000, while the total amount of Treasury securities declined by $396 billion, adding this amount to capital markets, federal agencies such as Freddie Mac and Fannie Mae were increasing their indebtedness by $1.3 trillion, taking that much back out of the markets. In short, Uncle Sam is giving with the one hand, while he takes with the other. It is as if a private individual took out a home equity loan to pay down his credit cards. His total debt has not changed, only its composition.

Ironically, a key reason for the flood of new federal securities pouring forth from federal agencies is to fill the demand for government bonds that are no longer being supplied by the Treasury. Indeed, Freddie Mac and Fannie Mae have made no secret of their desire to replace the Treasury’s role in capital markets. They aim to make their government-backed bonds the investment of choice for people and institutions that previously invested only in Treasuries.

An article by Federal Reserve economist Michael Fleming in the latest issue of the Brookings Papers on Economic Activity shows that Treasury bonds play a crucial role in setting prices in financial markets and facilitating monetary policy. Although agency securities may help fill the gap left by the declining availability of Treasury securities, we may not know the full implications of this substitution for some years.

In conclusion, those who think that paying down the national debt should be the first priority for using projected surpluses ought to be looking much more closely at what Fannie Mae and Freddie Mac are doing. They will see that the federal government’s total indebtedness is declining much less than they think. If it turns out there is a strong market demand for Treasury securities that will simply be satisfied by other forms of federal debt, then it greatly weakens the argument for paying down the national debt.

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