Government-sponsored enterprises ; Federal National Mortgage Association ; Mortgages ; Asset-backed financing

Deborah L. Martin

Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 91-44, December 20, 1991
Taxpayer Risk in Mortgage Policy
In the past fifty years, the government has set up
a number of financial institutions to aid in the
distribution of funds to credit markets. Recently,
these so-called government-sponsored enter-
prises (GSEs) have been under close scrutiny-in
April 1991, the Congressional Budget Office and
the Department of the Treasury released reports
concludingthat taxpayers potentially face con-
siderable risk from the GSEs, since the obliga-
tions of the GSEs are believed by the market to
enjoy implicit government backing.
We focus here on the Federal National Mortgage
Association (Fannie Mae), one of the largest
GSEs. Like the Federal Home Loan Mortgage
Corporation and the Government National Mort-
gage Association, its primary purpose is to facil-
itate the flow of funds to mortgage markets. In
this role, Fannie Mae has expanded rapidly over
the past ten years. Although Fannie Mae is ex-
posed to the type of interest rate risk and credit
risk common to mortgage lending, it borrows at
rates close to the Treasury's. Thus it would appear
that some sort of federal backing does exist. This
Weekly Letter evaluates the potential hazards of
this guarantee and updates earlier studies that
measure the extent to which Fannie Mae may
be exploiting its subsidy.
Fannie Mae
Fannie Mae was established in 1938 as a federal
agency. In 1968 it became what is called a Gov-
ernment-Sponsored Private Corporation. This
designation entitles the company to issue pub-
licly traded stock and to operate in much the
same way as a private corporation, yet maintain
certain ties to the government.
The reason for providing agency status to federal
housing credit programs originated with the
beliefthat mortgage markets need government
intervention to assist in the allocation of mort-
gage credit. The stated public purpose of Fannie
Mae is to smooth out regional imbalances in
mortgage funds, integrate local and regional mar-
kets, and increase the efficiency of the secondary
market. In theory, Fannie Mae increases housing
mortgage activity and therepy lowers consumer
mortgage costs.
Unlike thrifts, Fannie Mae does not originate
mortgages. Instead, it provides support to the
housing markets by buying mortgage loans origi-
nated by others (mostly commercial banks, mort-
gage banks, and thrifts). Fannie Mae's primary
purchases are conventional, single-family, fixed
and adjustable rate mortgages, subject to a max-
imum limit on the amount of each individual
mortgage set by Congress. In addition, Fannie
Mae sets underwriting guidelines, collateral re-
quirements, and loan terms of the mortgages that
it will acquire. Mortgage loans that meet all of
the guidelines are called conforming loans.
To purchase a conforming loan Fannie Mae has a
number of options. The simplest mechanism is to
purchase the loan outright. The loan then becomes
an asset of the Corporation and can be sepa-
rately resold or pooled with other loans and sold
as a new security now incorporating the Fannie
Mae guarantee. However, more commonly, Fan-
nie Mae allows lenders to exchange a pool of
mortgages for a security backed by those loans.
In the case of the "lender swap mortgage-backed
security;' the lender pays a fee and Fannie Mae,
in return, guarantees the timely payment of prin-
cipal and interest of the security.
In either case, Fannie Mae performs the role of a
"credit-enhancer"; that is, it provides a means
for investors to invest in pools of potentially risky
mortgages at reduced risk to the investor. To the
extent that its underwriting standards and lender
fee structures appropriately price the underlying
risk of the credit-enhanced mortgages, Fannie
Mae can perform this function without exposing
the federal government and taxpayers to risk.
The 1980s expansion.
In the 1980s Fannie Mae's total mortgage pur-
chases grew rapidly, increasing by almost 200
percent between 1980 and 1990. Part of theFRBSF
increase in activity during this period can be
attributed to congressional liberalization of pur-
chase price caps. However, a more significant
factor in Fannie Mae's expansion may have been
the weakening of the thrift industry in the
mid-1980s.
As the amount of capital in the thrift industry de-
clined, mortgage loans increasingly came to be
held outside of thrift portfolios, and originators
increasingly sold their mortgages to Fannie Mae.
Fannie Mae's dominance in the mortgage-backed
securities market, with its implicit guarantee,
also has led to lower interest rates on mortgage
loans. These lower interest rates diminish the
returns thrifts can earn by holding the loans in
portfolios, and hence are further incentive for
them to sell the mortgages. Likewise, the recent
risk-based capital standards for thrifts and banks
have worked to increase the volume of Fannie
Mae's mortgage-backed securities. The new
guidelines require lower risk-based capital for
mortgage-backed securities guaranteed by gov-
ernment-sponsored agencies than for mortgage
loans. Consequently, banks and thrifts have an
incentive to hold GSE mortgage securities, rather
than the mortgages themselves.
Does Fannie Mae exploit
the government's guarantee?
Some doubt the importance of these factors in
explaining the growth of Fannie Mae and instead
suspect that Fannie Mae was exploiting an under-
priced government guarantee implicit in the
agency status of its securities to the benefit of its
shareholders. Kane and Foster (1985) attempted
to estimate the value of Fannie Mae's federal
guarantee between 1978 and 1985. They arrived
at their estimates by marking Fannie Mae's assets
and liabilities to market and then backing out
the value of the guarantee from the value of its
stock. From this, the authors determined that the
value of the guarantee was always positive and
ranged from a low of $.6 billion in 1985 to
a high of $11.3 billion in 1981.
Schwartz and Van Order (1988) took the analysis
a step further and examined the extent to which
Fannie Mae was exploiting the guarantee. Using
Kane and Foster's calculation of the value of the
guarantee as given, they applied a variation of
Merton's (1977) option pricing model to deposit
insurance. The focus of Merton's model is the au-
dit interval, T. The firm is audited every T years
and at that time if the firm's economic net worth
is negative, it is shut down. Likewise, if the eco-
nomic net worth is positive, the firm must change
its operating policy or pay a higher insurance
premium. Although Fannie Mae is not officially
audited at fixed intervals and does not pay an in-
surance premium, Schwartz and Van Order also
focus on T, which is viewed as a measure ofthe
extent to which political pressure forces a change
in operating policy. A large T implies that Fannie
Mae is allowed to continue pursuing risky strat-
egies without political interference. If Fannie Mae
is not being audited at frequent intervals one
would expect management to maximize the value
of the firm by maximizing the value of the guar-
antee. Because the guarantee does not cost any-
thing, management may have the incentive to
take on as much risk as possible.
However, certain factors may limit the amount of
risk that management is willing to take on, such
as management's stake in the long-term survival
of the company. In addition, although Fannie
Mae is not audited regularly the possibility of
future sanctions by regulators still exists. Thus if
Fannie Mae does exploit the guarantee, it may
not do so to the fullest extent possible.
The authors used their model to estimate the au-
dit interval and to estimate the riskiness of Fannie
Mae's assets. Greater volatility ofthe assets, which
is accompanied by a larger audit interval, implies
that management is taking on more risk and ex-
ploiting the guarantee. They conclude that from
1978 to 1985 the guarantee was indeed being
exploited, though not to the full extent possible.
The audit interval was generally one to two years
and never exceeded three years.
An update on the evidence
Schwartz and Van Order's study only extended
through 1985, but since that time Fannie Mae has
been extremely profitable and has made a well-
publicized effort to reduce the possibility of run-
ning into financial trouble. By strengthening its
balance sheet the company has attempted to
limit its exposure to interest rate risk. Furthermore,
it adopted stricter loan guidelines in hopes of
reducing credit risk.
We attempt to determine if these changes en-
acted by Fannie Mae have improved its operating
procedure and limited risk enough to eliminate
the federal guarantee. Using the Schwartz and
Van Order model we estimated the audit interval,
and hence the extent of the guarantee, for 1986
through 1990 (see Chart 1). Our results indicate
that although the length of T has been reduced
slightly, a federal guarantee still existed in most
years. Except for 1987, when interest rates fell4.0
precipitously after the stock market crash, Twas
estimated to be around one year and never
more than two years. Thus, even in an interest
rate environment quite favorable to Fannie Mae,
evidence points to a federal guarantee that con-
tinues to be exploited to some extent.
Chart 1 Audit Interval
Trends in Fannie Mae's Federal Guarantee Year~
(As Implied By Estimated Audit Interval)
risk-taking. Fannie Mae's role in the mortgage
markets originated partially to offset cycles in
financial markets. However, the markets for
mortgages and other securities have changed
dramatically since Fannie Mae was first con-
ceived. In addition, regulated deposit rates in
earlier periods caused exaggerated cycles of dis-
intermediation and housing market volatility.
Since the financial reforms of the 1980s, these
factors are less relevant, as demonstrated em-
pirically by Pozdena (1990).
Kane, E., and C. Foster. 1986. "Valuing Conjectural
Government Guarantees of FNMA Liabilities:' In
Proceedings of a Conference on Bank Structure
and Competition. Federal Reserve Bank of Chicago.
The rapid growth of these private label mortgage-
backed securities in the face of their competitive
disadvantage with Fannie Mae, calls ihto ques-
tion the need for subsidized mortgage credit
GSEs. That is, the private market may now be in
a: position to provide the benefits of a liquid sec-
ondary market in mortgages without the atten-
dant taxpayer risk of the current institutional
arrangements.
The unsubsidized private sector likely would be
able to provide adequate secondary market serv-
ices. Indeed, they already do so in the market for
non-conforming mortgages (that is, those mort-
gages that do not qualify for government agency
purchase or securitization). Over $24 billion in
so-called private label mortgage-backed se-
curities were issued in 1990, for example, up
from only $2.4 billion in 1985.
RandallJ.Pozdena
Vice President
Deborah L. Martin
Research Associate
References
2.0
0.0
3.0
1.0
The fact that this guarantee exists is troublesome,
si nc~ it suggests that the scale of the guarantee
is under the control of Fannie Mae rather than
Congress or its constituents. As evidenced by the
analysts, the degree of exploitation of the guaran-
tee increased when Fannie Mae got into trouble
and fell during the profitable years. During 1981
when Fannie Mae was in its worst shape, the
length of the audit interval rose to about three
years and the volatility of its assets jumped to its
highest level. Conversely, during 1987, economic
conditions allowed Fannie Mae to prosper and
the value ofthe guarantee was close to zero.
l~lmlml~l~lmlmlml~l~
Source: 1987 to 1985, Schwartz &Van Order;
1986 to present, authors' estimates (average of high and low).
It would appear from this behavior that Fannie
Mae has a great deal of control over the amount
of the subsidy it receives from the government.
Because Fannie Mae does not have to pay for this
subsidy and is not closely regulated, taxpayer
exposure is potentially great, contained only by
Fannie Mae's desire to remain viable.
Merton, R. 1977. "An Analytical Derivation of the Cost
of Deposit Insurance and Loan Guarantees:' jour-
nal ofBanking and Finance (June) pp. 3-11.
Pozdena, R.J. 1990. "Do Interest Rates Still Affect
Housing?" Federal Reserve Bank of San Francisco
Economic Review (Summer) pp. 3-14,
Do we need GSEs?
A more fundamental question concerns the ben-
efits that the public receives as an offset to this
Schwartz, E., and R. Van Order. 1988. "Valuing the
Implicit Guarantee of the Federal National Mort-
gage Association." journal of Real Estate Finance
and Economics 1, pp. 23-34.
Opinions expressed in this newsletter do not necessariiy reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author...• Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
5/31 (91-22) Ending Inflation Judd/Motley
6/7 (91-23) Using Consumption to Forecast Income Trehan
6/14 91-24 Free Trade with Mexico? Moreno
7/5 91-25 Is the Prime Rate Too High? Furlong
7/19 91-26 Consumer Confidence and the Outlook for Consumer Spending Throop
7/26 91-27 Real Estate Loan Problems in the West Zimmerman
8/16 91-28 Aerospace Downturn Sherwood-Call
8/30 91-29 Public Preferences and Inflation Walsh
9/6 91-30 Bank Branching and Portfolio Diversification Laderman/Schmidt!
Zimmerman
9/13 91-31 The GulfWar and the U.S. Economy Throop
9/20 91-32 The Negative Effects of Lender Liability Hermalin
9/27 91-33 M2 and the Business Cycle Furlong/Judd
10/4 91-34 International Output Comparisons Glick
10/11 91-35 Is Banking Really Prone to Panics? Pozdena
10/18 91-36 Deposit Insurance: Recapitalize or Reform? Levonian
10/25 91-37 Earnings Plummet at Western Banks Zimmerman
11/1 91-38 Bank Stock Risk and Return Neuberger
11/8 91-39 The False Hope ofthe Narrow Bank Pozdena
11/15 91-40 The Regional"Concentration of Recessions Cromwell
11/22 91-41 Real Wages in the 1980s Trehan
11/29 91-42 Solving the Mystery of High Credit Card Rates Pozdena
12/13 91-43 The Independence of Central Banks Kim
The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.

An Analytical Derivation of the Cost of Deposit Insurance and Loan Guarantees:' journal ofBanking and Finance

Do Interest Rates Still Affect Housing?&quot; Federal Reserve Bank of San Francisco Economic Review (Summer) pp. 3-14, Do we need GSEs? A more fundamental question concerns the benefits that the public receives as an offset to this

Taxpayer risk in mortgage policy

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Taxpayer risk in mortgage policy

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