The big issues of mortgage-backed bonds are gaining unfairly from their association with the US government.
There is something reassuring about a company being associated with the government. Companies that have such a link, or were founded for public purposes, seem likely to serve the public good. But this often proves a false assumption. The pitfalls are particularly great when it comes to the realm of finance.
Consider the two such hybrid entities that loom over American capital markets, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The pair are often touted as the premier examples of felicitous public-private interaction. Even their nicknames, Fannie Mae and Freddie Mac, have a benign ring.
Certainly, the hybrids' histories sound auspicious. The two were created by the government- Fannie during the depression - not to sell mortgages directly to homeowners but to strengthen liquidity in the piecemeal residential mortgage market. They solved the problem by bundling these assets together and securitising them on bond markets.
The virtues of Fannie and Freddie seemed to be reinforced when they were privatised, Fannie in 1970 and Freddie in the 1980s. The message was clear. Government can launch an entity and then free it to expand in the private sector. Except that "expand" is too mild a word. Fannie and Freddie exploded, acquiring by the late 1990s sufficient assets to dwarf those of individual mortgage lenders.
Today their assets are worth several thousand billion - close to the size of interest-bearing Treasury debt held by the public. All along, the pair have advertised heavily: "Our business is the American dream" is Fannie's logo; Freddie's is "We open doors". Such efforts have won them a national reputation as the god-parents of home-owning.
These godparents are some of the financial market's most aggressive financial enterprises. They boast that they perform a social service for the home-owning middle class. They are helped in wooing customers by their fabulous credit rating - they are able to borrow at rates more favourable than many competitors and AAA-rated corporations, and only slightly less favourable than those enjoyed by the Treasury. They are listed among the other Fs on the New York Stock Exchange. All in all, quite a privatisation success story.
Except that the success has come in good part because Fannie and Freddie were never completely privatised. As authors Peter Wallison and Bert Ely point out, the giants enjoy a number of advantages over their wholly private competition.*
The president appoints members to their boards. The Treasury secretary may invest up to $2.25bn in their securities. Both companies are exempt from state and local taxes. And, most significantly, there is the general feeling that because of their social value and their size, the pair must not be allowed to fail.
Fannie and Freddie play down their public link, swearing they are as much subjects of market discipline as the next fellow. But the markets do not believe them. For one thing, Americans recall the savings and loan bail-out. The proof of investors' faith that the government stands behind Fannie and Freddie is the lower cost of borrowing.
Such power has generated serious concern in Washington, both at the Federal Reserve and Congress. Yet Fannie and Freddie are wealthy enough to strike back: in election 2000 they sought to assure their unique status by pouring more that $4m into political contributions to both parties, up from $1.3m in the prior election cycle. Nor are the pair shy about assailing critics: after private mortgage groups formed a watchdog group - www.fmwatch.com - to monitor them, Fannie slammed it as an "anti-consumer pact".
When Franklin Raines, Fannie's chairman, was mooted as a possible vice-presidential candidate, the press joked that Mr Raines would never accept an offer: he already held a more powerful office. But concerns over Fannie's and Freddie's size are legitimate.
For one thing, the pair may already be distorting markets - luring Americans into homebuying when they might better invest elsewhere. For another, the pair are growing so fast that they now threaten to consume the entire mortgage market, doing the damage of classic monopolies. Alan Greenspan, the Fed chairman, has warned about this possibility, noting that the Fannie and Freddie can distort markets by "diverting real resources from other market-determined uses".
And what if the pair get into financial problems, just as lenders including the savings and loans have in the past? Fannie and Freddie's assets are held by so many US banks that their weakening would pose the threat of systemic risk. It is possible they would require a federal bail-out. This would be hard to refuse, and far costlier than the savings and loan rescue, which ran under $200bn.
But the biggest danger is America's emerging federal surplus. Washington is retiring its own debt, so it must hold the surplus in something else: private assets. High on the list of likely purchases are Fannies and Freddies. Governments ought to be able to unload such assets when they are no longer a good investment. But what politician wants to be seen driving down the value of a national home dream machine?
Not that Fannie and Freddie are the only firms facing the danger of increased politicisation in the surplus world. As Mr Greenspan warned, federal investment in private assets "would risk sub-optimal performance by our capital markets, diminished economic efficiency and lower overall standards of living". Still, Fannie and Freddie are evidence of a special double hazard - that of allowing "public-private" entities to become players in financial markets.
* Nationalizing Market Risk; American Enterprise Institute.
© Copyright 2001 Financial Times
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