Federal Reserve Chairman Alan Greenspan took aim at political and economic behemoths Freddie Mac and Fannie Mae recently, pointing to the potential financial shockwaves that their collapse could cause. Mr. Greenspan’s comments highlight the need for Congress to act once and for all to tighten the regulations on the government-sponsored mortgage giants, but lawmakers should carefully consider some of Mr. Greenspan’s specific recommendations.
Freddie and Fannie buy mortgages from banks and savings and loans, keeping some of the mortgages on their own books and repackaging others to sell as securities, known as mortgage-backed securities. Given their government charter, the companies face less stringent disclosure requirements than other publicly traded companies, and are widely believed to be guaranteed by the government against default — although that guarantee is not explicit. The companies are among the four largest financial institutions in America.
In testimony to the Senate Banking, Housing and Urban Affairs Committee, Mr. Greenspan called on Congress to limit the size of Fannie’s and Freddie’s portfolio. “Without restrictions on the size of [their] balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for home ownership,” he said. That comment is in keeping with a statement he made to Congress in February, which called for limiting the size of the companies’ portfolios to between $100 billion and $200 billion. The companies’ combined portfolio is now about $1.5 trillion.
Mr. Greenspan’s statement reflects much of the widely held concern about Freddie and Fannie. The two companies have become so large, that the collapse of either one would have a substantive impact on the overall economy. By limiting the companies’ portfolio, the potential economic impact of Freddie’s or Fannie’s downfall would be minimized and the cost of a government bailout would be reduced.
However, an abrupt change in the interest-rate environment — the principal risk faced by Freddie and Fannie — would still affect the holders of the mortgages that Freddie and Fannie sell. Commercial banks would be the primary purchasers of those mortgages. Since much of the deposits in banks are federally insured, the taxpayer would still be on the hook if banks were to enter a crisis as a result of their mortgage exposure, and many banks have also become too big to fail. Still, banks have more diversified risk than do Freddie and Fannie and the potential for catastrophic human mismanagement would be mitigated by having mortgages held by a greater number of parties. Therefore, reducing the size of Freddie’s and Fannie’s assets, or limiting their future growth, would help ensure against the collapse of either companies.
There are consequences to such a measure, though. The size of Freddie’s and Fannie’s portfolio has made the mortgage market extremely liquid, which has helped to keep mortgage rates low. A reduction in their portfolios would have an impact on borrowing costs for homeowners, though the size of that impact is debated by economists. Young and minority homeowners would be particularly affected by that increase in borrowing costs, and home ownership would decline. The construction industry would also be affected. A decline in new home construction would cause the price of existing housing to rise.
Lawmakers should hold hearings to try to quantify just what the impact a reduction in Fannie’s and Freddie’s size would have on mortgage rates, the construction industry and cost of existing housing. They should also try to determine how much “insurance” such a restriction on Freddie and Fannie would provide against a disastrous impact on the economy. While we agree that a catastrophic failure at the companies needs to be avoided even at a high cost, Congress should be aware just how high the costs could be, and consider the cultural benefits of home ownership in America, particularly young America.