December 22, 2010
Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market
December 22, 2010
Two years ago, the federal government assumed control of the ailing Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), two institutions that facilitate the flow of funding for home loans nationwide. The cost to taxpayers of that takeover, and the structural weaknesses that contributed to the institutions’ financial problems, have prompted policymakers to consider various alternatives for the government’s future role in the secondary (resale) market for residential mortgages.
This study looks at how Fannie Mae and Freddie Mac evolved into the institutions they are today. As context for discussing future options, the study also examines both the rationales that are often cited for federal involvement in the secondary mortgage market and the problems with Fannie Mae and Freddie Mac that existed before the recent financial crisis. The secondary market channels funds to borrowers by facilitating the resale of mortgages and mortgage-backed securities (MBSs). In that market, lenders such as banks, thrifts, and mortgage companies obtain funding for the loans they originate by selling the loans to purchasers such as Fannie Mae, Freddie Mac, and other financial institutions (including banks and insurance companies).
Alternative proposals for the secondary mortgage market involve different choices about whether the federal government should continue to guarantee payment on certain types of mortgages or MBSs and, if so, what the scope, structure, and pricing of those guarantees should be. The proposals also involve choices about support for affordable housing and the competitive structure and regulation of the secondary market. This study examines the trade-offs involved in making those key design choices and evaluates the strengths and weaknesses of three broad approaches for the future of the secondary mortgage market:
- A hybrid public/private model in which the government would help to ensure a steady supply of mortgage financing by providing explicit guarantees on privately issued mortgages or MBSs that met certain qualifications;
- A fully public model in which a wholly federal entity would guarantee qualifying mortgages or MBSs; or
- A fully private model in which there would be no special federal backing for the secondary mortgage market.
This analysis focuses primarily on the long-term strengths and weaknesses of the alternative approaches, not on the transition from the status quo to a new model. Transitional issues--such as what to do with the existing portfolios and obligations of Fannie Mae and Freddie Mac--are important in their own right, but they are largely separate from the questions about the long-term future of the secondary mortgage market that are examined here. In particular, alternative ways of resolving the transitional issues probably would not substantially affect the relative long-term merits of different models for the secondary market, and the different models do not appear to require any particular resolution of the transitional issues--choices about each could be combined in various ways. If changes were made in the next few years, care would need to be taken not to disrupt the housing and mortgage markets further. Those markets remain fragile: The sharp decline in housing prices since mid-2006 has left many homeowners owing more on their mortgages than their homes are worth, foreclosure rates are still high, and obtaining a mortgage continues to be difficult for many households.
Fannie Mae, Freddie Mac, and the Secondary Mortgage Market
Four decades ago, Congressional charters set up Fannie Mae and Freddie Mac as government-sponsored enterprises (GSEs)--privately owned financial institutions established by the government to fulfill a public mission. The two GSEs were created to provide a stable source of funding for residential mortgages across the country, including loans on housing for low- and moderate-income families. Fannie Mae and Freddie Mac carry out that mission through their operations in the secondary mortgage market. They purchase mortgages that meet certain standards from banks and other originators, pool those loans into mortgage-backed securities that they guarantee against losses from defaults on the underlying mortgages, and sell the securities to investors--a process referred to as securitization. In addition, they buy mortgages and MBSs (both each other’s and those issued by private companies) to hold in their portfolios. They fund those portfolio holdings by issuing debt obligations, known as agency securities, which are sold to investors.
Until recently, the GSEs’ debt securities and MBSs were not officially backed by the federal government. Nevertheless, most investors believed that the government would not allow Fannie Mae and Freddie Mac to default on their obligations. That perception of an implicit federal guarantee stemmed from the very prominent role the two entities played in the housing market and in the broader financial markets. It also stemmed from the specific benefits that the two entities received because of their status as GSEs, such as not having to register their securities with the Securities and Exchange Commission, being exempt from state and local corporate income taxes, and having a line of credit with the Treasury.
Because of their implicit federal guarantee, Fannie Mae and Freddie Mac could borrow to fund their portfolio holdings at much lower interest rates than those paid by fully private financial institutions that posed otherwise comparable risks, and investors valued the GSEs’ credit guarantees more highly than those issued by fully private guarantors. Some of those benefits from federal support flowed to mortgage borrowers in the form of greater availability of credit and somewhat lower interest rates. The GSEs’ other stakeholders (shareholders, managers, and employees) also reaped some of the gains. The advantages of implicit federal support allowed Fannie Mae and Freddie Mac to grow rapidly and dominate the secondary market for the types of mortgages they were permitted to buy (known as conforming mortgages). In turn, the perception that the GSEs had become “too big to fail” reinforced the idea that they were federally protected.
Fannie Mae and Freddie Mac were profitable in most years until recently, when the United States experienced its most severe financial crisis since the Great Depression of the 1930s. As housing prices dropped nationwide and foreclosures increased, the two GSEs suffered large losses on various investments in their portfolios, such as subprime mortgages (loans made to borrowers with poorer-than-average credit) and “private-label” MBSs (securities issued and insured by private companies without government backing). The GSEs also faced heightened uncertainty about the magnitude of the ultimate decline in housing prices and increase in unemployment and thus about the size of credit losses on their outstanding guarantees (which in September 2008 totaled $3.8 trillion). Those factors impaired the GSEs’ ability to issue low-cost debt to fund their mortgage purchases, and doubts arose about whether they had enough capital to cover potential losses.
The enactment of the Housing and Economic Recovery Act of 2008 (Public Law 110-289) established the Federal Housing Finance Agency and gave it the authority to place Fannie Mae and Freddie Mac in conservatorship-- a step it took in September 2008. The Treasury was granted the authority to provide the GSEs with unlimited capital (by purchasing their stock) in order to maintain their solvency through 2012. Those actions gave the government control over the two institutions and effectively made the government’s backing of their debt securities and MBS guarantees explicit.
As a result of that aid and the explicit federal guarantee, Fannie Mae and Freddie Mac were able to continue channeling funds to the mortgage market, even as private financial institutions were faltering. Consequently, in 2009, the two GSEs owned or guaranteed roughly half of all outstanding mortgages in the United States (including a significant share of subprime mortgages), and they financed three-quarters of new mortgages originated that year. Including the 20 percent of home loans insured by federal agencies, such as the Federal Housing Administration (FHA), more than 90 percent of new mortgages made in 2009 carried a federal guarantee.
Possible Rationales for a Federal Role in the Secondary Market
In assessing future options for Fannie Mae and Freddie Mac, a fundamental issue is what role, if any, the federal government should play in the secondary mortgage market. Historically, support for that market has been part of a broader federal housing policy aimed at encouraging home ownership and, to a lesser extent, at making housing more affordable for low- and moderate-income families. The activities of Fannie Mae and Freddie Mac have been an important aspect of that policy, although the largest federal subsidies for home ownership have generally come from favorable tax treatment for housing.
Federal policies that affect the secondary market are mainly intended to achieve two public purposes:
- Helping to ensure a steady supply of financing for residential mortgages, and
- Providing subsidized assistance for mortgages on housing for low- and moderate-income families.
The government has pursued those goals largely through policies that increase the liquidity of mortgages and mortgage-backed securities. In a liquid market, investors can quickly buy or sell large quantities of an asset without affecting its price. The government can enhance the liquidity of the secondary mortgage market by providing credit guarantees, which make MBSs safer and thus easier for investors to value, and by standing ready to buy and sell MBSs. Such government support has the greatest impact on the availability and price of mortgage funding during disruptions in the financial markets. At such times, interruptions in the supply of mortgage credit can spill over to the market for new-home construction and weaken the broader economy. Such interruptions can also impede labor mobility by making it more difficult for people to buy and sell homes when they want to move.
Supporting liquidity in the secondary mortgage market through federal credit guarantees tends to lower interest rates only slightly for most mortgage borrowers under normal market conditions. When mortgages are unsubsidized, the cost of providing a credit guarantee is offset by the fees charged to investors, and those guarantee fees are passed on to borrowers. Nevertheless, borrowers may benefit because investors are willing to pay somewhat higher prices (or, equivalently, accept lower interest rates) for MBSs that are more liquid. In a competitive marketplace, that advantage tends to reduce the rates paid by borrowers relative to what rates would be in the absence of federal guarantees. (To the extent that Fannie Mae and Freddie Mac are able to dominate the market for MBSs, the value of greater liquidity may accrue largely to them rather than to borrowers.)
The benefits of the government’s actions to increase liquidity in the secondary market by providing credit guarantees and purchasing mortgages must be weighed against the costs. Those actions expose taxpayers to the risk of potentially large losses when the cost of honoring guarantees exceeds the value of guarantee fees collected--or when mortgages held by the government lose value because of changes in interest rates or prepayment rates (that is, the extent to which borrowers pay mortgages off early). Federal guarantees also reduce the incentive for mortgage originators to avoid making risky loans in the first place.
Besides encouraging a stable supply of financing, another objective of federal involvement in the secondary mortgage market is to increase the availability of credit and subsidize its costs for people with low or moderate income. Broadening access to home ownership could be beneficial because owning a home may give people a greater stake in their community and thus make communities more stable. Moreover, certain types of housing assistance may be provided more effectively through support for the secondary market than through grants or tax preferences. For example, some borrowers may have the financial means to own a home but have trouble obtaining private credit--a problem known as “credit rationing.” That problem can occur when it is difficult for lenders to assess the riskiness of certain borrowers, such as those with short credit histories. Lenders cannot address that greater risk by charging higher interest rates, because such terms tend to attract borrowers who are more likely to default. However, the government may decide that the value to society from subsidizing certain loans is greater than the cost of doing so.
Currently, several federal agencies--including the FHA, the Department of Veterans Affairs (VA), and the Government National Mortgage Association (Ginnie Mae)--provide assistance to low- and moderate-income borrowers through the secondary market, as (to a more limited extent) do Fannie Mae and Freddie Mac. The FHA and VA increase the flow of credit to such borrowers by explicitly insuring mortgages against losses from default, and Ginnie Mae guarantees the payment of interest and principal on MBSs backed by pools of those mortgages. Fannie Mae and Freddie Mac are required to provide support for affordable housing by meeting certain goals set by regulators. Those goals specify the percentage of the GSEs’ mortgage guarantees and purchases that must involve loans used to finance rental housing for, or home purchases by, people with low or moderate income.
Weaknesses of the Precrisis Model
Despite the potential beneficial effects of federal involvement in the secondary mortgage market, the rules and market structure under which Fannie Mae and Freddie Mac operated before conservatorship--referred to in this study as the precrisis model--had numerous weaknesses. Those weaknesses included the following:
- Adverse effects from the implicit federal guarantee of the two GSEs (such as a concentration of market power, risks to the stability of the larger financial system, incentives for excessive risk taking, and a lack of transparency about costs and risks to the government);
- Limited effects on affordable housing;
- Lax regulation; and
- Tensions in trying to balance competing public and private goals.
The implicit federal guarantee concentrated market power in Fannie Mae and Freddie Mac by giving them lower funding costs than potential competitors in the secondary market. As a consequence, the GSEs grew to dominate the segments of the market in which they were allowed to operate. Because of their size and interconnectedness with other financial institutions, they posed substantial systemic risk--the risk that their failure could impose very high costs on the financial system and the economy. The GSEs’ market power also allowed them to use their profits partly to benefit their other stakeholders rather than exclusively to benefit mortgage borrowers.
The implicit guarantee created an incentive for the GSEs to take excessive risks: Stakeholders would benefit when gambles paid off, but taxpayers would absorb the losses when they did not. (Financial institutions that lack the benefit of a federal guarantee have less incentive to take risks because doing so can increase their financing costs, although some still act imprudently at times.) One way that Fannie Mae and Freddie Mac increased risk was by expanding the volume of mortgages and MBSs held in their portfolios, which exposed them to the risk of losses from changes in interest or prepayment rates. Over the past decade, the two GSEs also increased their exposure to default losses by investing in lower-quality mortgages, such as subprime and Alt-A loans.
Because the federal guarantee was implicit rather than explicit, the costs and risks to taxpayers did not appear in the federal budget. That lack of transparency made it more difficult for policymakers to assess and control the GSEs’ costs and risks. Lack of transparency also made it difficult for policymakers to evaluate whether the GSEs were effectively and efficiently meeting their affordable-housing goals; several studies have questioned the effectiveness of the GSEs’ affordable-housing activities.
Weak regulation was a further shortcoming of the pre-crisis model. For instance, until 2008, the GSEs’ regulators lacked the power to increase capital requirements for Fannie Mae and Freddie Mac or to place them in receivership--powers that regulators have long had over banks.
Finally, as private companies with a public mission and implicit public backing, Fannie Mae and Freddie Mac faced an intrinsic tension in balancing the objectives of maximizing profits for their shareholders, maintaining safety and soundness to minimize potential costs to taxpayers, and supporting affordable housing. For example, efforts to help low-income households tend to involve targeting loans toward borrowers who generally pose more risk than borrowers of traditional conforming mortgages do, thereby putting taxpayers at greater risk of loss. The affordable-housing goals and the pursuit of profit may have encouraged Fannie Mae and Freddie Mac to purchase subprime MBSs that were expected to generate high returns but that involved excessive risk for borrowers and taxpayers alike.
Alternative Approaches for the Future of the Secondary Mortgage Market
The weaknesses inherent in the precrisis model may argue against returning to that model after the GSEs’ conservatorship ends. A broad array of alternatives are possible for the federal government’s future role in the secondary mortgage market. Any new approach would need to confront major design issues, such as whether to have federal guarantees and, if so, how to structure and price them; whether to support affordable housing and, if so, by what means; and how to structure and regulate the secondary market.
The Congressional Budget Office (CBO) analyzed three broad alternatives for structuring the secondary mortgage market:
- Adopting a hybrid public/private approach that would involve explicit federal guarantees of some privately issued mortgage-backed securities;
- Establishing a fully federal agency that would purchase and guarantee qualifying mortgages; or
- Promoting a fully private secondary market with no federal guarantees.
In examining those broad approaches, CBO looked at a number of criteria, including whether a given alternative would ensure a stable supply of financing for mortgages, how affordable-housing goals would be met, how well taxpayers would be protected from risk, whether federal guarantees would be priced fairly, and to what extent an approach would provide incentives to control risk taking.
Managing the Transition to a New Approach
Moving from the current operations of Fannie Mae and Freddie Mac under conservatorship to any new model would involve several transitional issues, including how to manage the GSEs’ existing portfolios and guarantee obligations and what to do with their operating assets. The government faces two basic choices: either retain the GSEs’ portfolios and the responsibility for their outstanding guarantees and allow both to run out as mortgages are paid off, or pay a private entity to assume the guarantee obligations and sell off the portfolios. Whatever model for the secondary market is ultimately adopted, the expected losses on the GSEs’ existing business will largely be borne by taxpayers, because private investors would not assume those obligations without compensation. The GSEs’ operating assets are valuable; they could be auctioned off to investors (with the proceeds helping to offset some of the losses to taxpayers) or kept for use by a federal agency.
This study does not address those transitional issues in depth. Handling them efficiently and without disruption to the secondary mortgage market--especially given current conditions in housing and mortgage markets--is both important and difficult. However, in CBO’s judgment, those issues have little impact on the relative merits of various approaches for the long-term organization of the secondary market, which is the focus of this study.
Major Design Issues
Many different models for the secondary mortgage market involve common design issues, such as how to structure and price any federal credit guarantees, whether and how to support affordable housing, and how to structure and regulate the secondary market.
Structuring Federal Guarantees. The design of federal guarantees is an important issue for both a hybrid public/private approach and a fully federal approach. A key choice involves which mortgages would be considered eligible for federal guarantees. Mortgage products that qualify for federal backing tend to be popular, and hence such backing can be used to encourage best practices by lenders. Including a wide range of products in the definition of qualifying mortgages--and setting high dollar limits for those loans--would provide benefits to more borrowers and could increase the stability of the secondary market. At the same time, a large-scale guarantee program would expose the government to greater risk, reduce the incentives for prudent risk taking, and tend to crowd out private participation in the market.
The government could charge guarantee fees that partly or fully offset the total expense of its guarantee program, including administrative costs, expected losses, and the cost of risk. (If fees and other collections were insufficient to cover those costs, the government would have to subsidize the program.) Basing guarantee fees on the riskiness of a mortgage would weaken the incentive for excessive risk taking and reduce the extent to which safer borrowers cross-subsidized riskier ones.
Some proposals envision providing federal guarantees but limiting the government’s exposure to risk by sharing risk with the private sector. Under such proposals, private capital--along with homeowners’ down payments and any capital provided by private mortgage insurance--would be the first line of defense against losses from defaults. Transferring risk to the private sector would not only lower the government’s exposure directly but also give private entities greater incentives to control risk and thereby reduce the government’s exposure further.
One risk-sharing option that could limit federal losses would be for the government to sell catastrophic risk protection on qualifying MBSs. With catastrophic guarantees, payouts to investors might be triggered, for instance, only when nationwide default rates exceeded some threshold. Smaller losses would be absorbed by private capital or insured by private mortgage insurance. Relying heavily on the private sector for credit protection would have drawbacks, however. Investors would probably perceive securities with very limited federal backing as being riskier and less uniform than those currently issued by Fannie Mae and Freddie Mac, which would make them less liquid. The availability of private capital and private mortgage insurance is also susceptible to disruptions in the financial markets.
Supporting Affordable Housing. The main design issue related to affordable housing is whether to transfer the GSEs’ responsibilities in this area to fully federal entities (such as the FHA) that are funded with broad-based taxes or to pursue affordable-housing goals through taxes or mandates on private institutions operating in the secondary mortgage market. Supporting affordable housing generally involves providing subsidies, which are most easily controlled and monitored when administered by a federal agency. Some observers, however, question whether a federal agency could provide support as effectively or flexibly as private entities; in their view, it would be better to have such support remain the responsibility of private financial institutions.
In the precrisis model, the GSEs’ affordable-housing activities were effectively funded through the financial advantage generated by the government’s implicit guarantee. Under alternative approaches with an explicit federal guarantee, the fees charged to investors would probably either just cover or not entirely cover the government’s cost for the guarantee program and so would not generate a surplus that could be used to support affordable housing. Thus, the alternatives to fund affordable-housing activities would be either to use general revenues or to use special taxes or mandates on financial institutions. Broad-based taxes tend to be less distorting and hence preferable in terms of economic efficiency, although special assessments on financial institutions might be justified as compensation for benefits that those institutions receive from the government.
Structuring and Regulating the Secondary Market. Key issues related to the structure of the market include what role private-label securitizers would play, how much they would be regulated, and whether any of the GSEs’ advantages would be extended to other market participants or abolished. For a hybrid public/private approach, another critical design issue is how the market would be structured--specifically, the number and types of intermediaries that would exist and the activities they would be permitted to engage in. Proposals range from licensing a small number of highly regulated private entities to package and sell federally guaranteed MBSs (the “public-utility model”) to allowing any private financial institution that met certain regulatory criteria to package and sell federally guaranteed MBSs (the “competitive market-maker model”).
An argument in favor of the public-utility model is that it could create a more level playing field for mortgage originators than a less regulated approach would; the public utilities would be required to serve all originators, thereby facilitating broad access to the secondary market. In addition, having a small number of intermediaries could increase the liquidity of the secondary market by ensuring that investors viewed different federally backed MBSs as interchangeable. If the intermediaries were structured as nonprofit entities, they might also have less incentive to take risk than for-profit firms do.
If the public utilities’ business was limited to creating federally backed MBSs, however, they would be more exposed to mortgage credit risk than would financial institutions with a more diverse set of investments.
Concentrating risk exposure would replicate one of the major weaknesses of Fannie Mae and Freddie Mac and make the new public utilities more susceptible to shocks in the housing market than more-diversified institutions would be. In addition, having only a few large intermediaries that were essential to the functioning of the secondary market could recreate the “too big to fail” problem, even if federal guarantees were limited by law. And nonprofits might have weaker incentives than private-sector institutions do to control costs and risks and to innovate. Another concern with the public-utility model is “regulatory capture”--that over time, regulators might become more responsive to the goals of the regulated entities than to the interests of the general public.
The competitive market-maker model also has strengths and weaknesses. On the one hand, spreading mortgage credit risk more widely among more-diversified institutions would reduce risks to the overall financial system and the economy, compared with both the precrisis model and the public-utility model. Having a greater number of institutions issue federally backed MBSs would also encourage innovation and foster competition--which could help ensure that the benefits of federal support went to mortgage borrowers rather than to stakeholders of the financial intermediaries.
On the other hand, even with a federal guarantee, MBSs issued by different institutions might not be viewed as completely interchangeable. In that case, the liquidity of MBSs would be reduced, and borrowing costs would increase. It is also possible that smaller mortgage originators might have trouble gaining access to the secondary market if large private institutions were unwilling to buy loans from them, although competition among market makers would make that outcome unlikely. Another concern with allowing broad participation by diversified firms is that the government could be exposed to greater risk because losses from firms’ other lines of business could spill over to their activities in the secondary mortgage market.
A Hybrid Public/Private Model
Many proposals for the future of the secondary market involve providing federal guarantees of certain mortgages or MBSs that would qualify for government backing. That approach would preserve many features of how the secondary market for conforming mortgages operated before Fannie Mae and Freddie Mac were placed in conservatorship. However, a hybrid approach would depart from the precrisis model in three main ways: A potentially different set of private intermediaries would be established to securitize federally backed mortgages, the federal guarantees on those mortgages would be explicit rather than implicit, and their subsidy cost would be recorded in the federal budget.
As the preceding discussions about structuring federal guarantees and regulating the secondary mortgage market illustrate, a hybrid approach could be implemented in ways that involved broader or narrower federal guarantees and more or less regulation of participants in the market. Under a hybrid approach, private capital and possibly private mortgage insurance would absorb credit losses before the federal guarantee would be called upon. Fannie Mae and Freddie Mac could be privatized and allowed to compete in the secondary market; they could be used to form a nonprofit organization that would issue federal guarantees; or they could be liquidated. The government could provide additional housing assistance to low- and moderate-income families by subsidizing guarantee fees for qualifying borrowers or by funding programs of the FHA or other federal agencies that target those groups.
Compared with the approach of establishing a fully federal agency, a hybrid public/private approach would lessen concerns about putting a large portion of the capital market under government control. It would also limit costs and risks to taxpayers by having intermediaries in the secondary market bear all credit losses until their capital was exhausted. In addition, putting private capital at risk would provide incentives for prudent underwriting and pricing of risk. Compared with a fully private secondary market, a hybrid approach would probably improve the liquidity of the market, especially during times of financial stress. Moreover, providing an explicit federal guarantee would avoid the problems of lack of transparency and control that an implicit guarantee involves.
Relying on explicit government guarantees of qualifying mortgages would also have some disadvantages, the importance of which would depend partly on the design chosen. If competition remained muted, with only a few specialized firms participating in the secondary market, limiting risk to the overall financial system and avoiding regulatory capture could be difficult. Moreover, federal guarantees would reduce creditors’ incentive to monitor risk. Experience with other federal insurance and credit programs suggests that the government would have trouble setting risk-sensitive prices and would most likely end up imposing some cost and risk on taxpayers. In addition, a hybrid approach might not eliminate the frictions that arise between private and public missions.
A Fully Federal Agency
An alternative would be to create a government-run program that would provide explicit federal guarantees promising timely payment of interest and principal on qualifying mortgages or MBSs. (Such a program could share many features with the current activities of the FHA and Ginnie Mae.) The net cost of the federal program would appear in the budget and could be covered wholly or partly by charging guarantee fees. Policymakers could use the design of the fees to determine the size of subsidies to low-income borrowers or providers of low-income rental housing. Under that fully federal approach, some of the existing operations of Fannie Mae and Freddie Mac could become part of a new or existing federal agency.
A federally run program could have some advantages over alternatives that relied on the private sector. For example, such a program would be more likely to ensure a fairly steady flow of funds to the secondary mortgage market--both in normal times and during periods of financial stress--by minimizing uncertainty about the strength of the federal guarantee. Compared with the precrisis model, this approach would increase transparency by replacing an implicit guarantee with an explicit one. Moreover, most of the federal subsidies would probably flow to mortgage borrowers rather than to private financial institutions.
At the same time, however, a new federal program would permanently increase government control of a large segment of the capital market. Depending on the size of the subsidies, that greater federal presence could tilt the allocation of capital in the economy further toward housing and away from other activities. In addition, a federally operated secondary market would probably be less dynamic and result in fewer innovations than a market in which competing private institutions played a larger role. Furthermore, taxpayers, rather than private financial institutions, would bear much of the credit risk on guaranteed mortgages. That shift in risk bearing might give mortgage originators and other financial intermediaries less incentive to control risk--a situation (known as moral hazard) that commonly arises with guarantees and insurance.
Depending on the specific budgetary treatment of the program, the government could have weaker incentives than private parties do to charge guarantee fees that would fully compensate for the risks associated with the guarantees. Currently, the budgetary treatment of most federal credit guarantees follows the guidelines of the Federal Credit Reform Act of 1990, which do not include a charge for market risk in estimates of federal subsidies. As a result, such estimates tend to understate a guarantee’s economic cost to taxpayers.
A Fully Private Secondary Mortgage Market
Another approach would be to move to a fully private secondary mortgage market and either wind down the operations of Fannie Mae and Freddie Mac or sell the federal stake in their assets to private investors. Responsibility for carrying out the GSEs’ affordable-housing mission, to the extent it was continued, could be transferred to a government housing agency, such as the FHA. Private firms would then form the secondary market--just as they did for private-label MBSs before the recent financial crisis and as they continue to do for securities backed by other types of assets (such as automobile, student, commercial real estate, and credit card loans). In times of severe distress, the government could still step in to promote liquidity. For instance, it could make FHA guarantees available to more borrowers, or it could buy MBSs (as the Treasury and the Federal Reserve did during the financial crisis). Expanding the activities of federal agencies, however, generally requires Congressional action.
Privatization might provide the strongest incentive for prudent behavior on the part of financial intermediaries by removing the moral hazard that federal guarantees create. (The enormous losses that have occurred in recent years on private-label subprime mortgages, however, offer a painful reminder that private markets are not immune to aggressive risk taking.) By increasing competition in the secondary market, the privatization approach would reduce the market’s reliance on the viability of any one firm. Private markets may also be best positioned to allocate the credit risk and interest rate risk of mortgages efficiently, and they would probably be more innovative than a secondary market dominated by a fully federal agency. Further, privatization would eliminate the tension between public and private purposes inherent in the traditional GSE model.
Full privatization could have several drawbacks, however, including the risk that it might not prove credible. If the private firms operating in the secondary market were seen as critical to the functioning of the mortgage market, investors might again treat them as implicitly guaranteed by the government, weakening market discipline, reducing transparency, and creating moral hazard. In addition, without some predictable federal response, the liquidity of the private secondary market might dry up during periods of acute financial stress. Moreover, privatization might not significantly reduce taxpayers’ overall exposure to risk if it shifted credit risk on mortgages to banks that were covered by federal deposit insurance and if that additional risk was not recognized in regulators’ actions and in the fees charged for deposit insurance.
Other Mortgage-Financing Approaches
As an alternative to mortgage-backed securities, the federal government could offer support for other funding mechanisms for home loans. One possibility would be to encourage greater reliance on covered bonds--bonds collateralized by residential mortgages--which many large European banks use to fund the mortgages they hold. With covered bonds, banks bear most of the risks of mortgage lending: When a mortgage is paid off or goes into default, the issuer is contractually obligated to replace the collateral with a new mortgage. That allocation of risk has both advantages and disadvantages compared with MBSs, which spread risk more widely among financial institutions, investors, and the government.
Other developed countries with high rates of home ownership rely less on government-backed MBSs to fund mortgages than the United States does. Some observers have pointed to Europe’s housing finance systems as potential models for this country; those systems have supported rates of home ownership comparable with that in the United States while relying less on MBSs. Although covered bonds are common in Europe, there is considerable variation in how mortgages are funded and what types of mortgages are available. Nevertheless, all developed countries with high rates of home ownership depend on some degree of government support to maintain the flow of credit to the mortgage market during periods of financial stress.
Report on the Troubled Asset Relief Program -- November 2010
November 29, 2010
In October 2008, the Emergency Economic Stabilization Act of 2008 established the Troubled Asset Relief Program (TARP) to enable the Department of the Treasury to purchase or insure troubled assets as a way to promote stability in financial markets. Section 202 of that legislation requires the Congressional Budget Office (CBO) to prepare a report on those transactions within 45 days of a report issued by the Office of Management and Budget (OMB) on the TARP's activities. This fourth statutory report from CBO on the TARP's transactions follows the report that OMB submitted to the Congress on October 15, 2010.
In October 2008, the Emergency Economic Stabilization Act of 2008 (Division A of Public Law 110-343) established the Troubled Asset Relief Program (TARP) to enable the Department of the Treasury to promote stability in financial markets through the purchase and guarantee of "troubled assets." Section 202 of that legislation requires the Office of Management and Budget (OMB) to submit semiannual reports on the costs of the Treasury's purchases and guarantees of troubled assets. The law also requires the Congressional Budget Office (CBO) to prepare an assessment of each OMB report within 45 days of its issuance. That assessment must discuss three elements:
- The costs of purchases and guarantees of troubled assets,
- The information and valuation methods used to calculate those costs, and
- The impact on the federal budget deficit and debt.
To fulfill its statutory requirement, CBO has prepared this report on transactions completed, outstanding, and anticipated under the TARP as of November 18, 2010. CBO estimates that the cost to the federal government of the TARP's transactions (also referred to as the subsidy cost), including grants that have not been made yet for mortgage programs, will amount to $25 billion (see Table 1). That cost stems largely from assistance to American International Group (AIG), aid to the automotive industry, and grant programs aimed at avoiding foreclosures. Other transactions with financial institutions will, taken together, yield a net gain to the federal government, CBO estimates.
CBO's current estimate of the cost of the TARP's transactions is substantially less than the $66 billion estimate incorporated in the agency's latest baseline budget projections (issued in August 2010) and the $109 billion estimate shown in the agency's previous report on the TARP (issued in March 2010). The reduction in estimated cost over the course of this year stems from several developments: additional repurchases of preferred stock by recipients of TARP funds; a lower estimated cost for assistance to AIG and to the automotive industry; lower expected participation in mortgage programs; and the elimination of the opportunity to use TARP funds for new purposes (because of the passage of time and the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203). CBO's current estimate is also well below OMB's latest estimate, $113 billion, because the market value of assets held by the government has increased and several recipients of TARP funds — most notably General Motors and AIG &mdash have significantly restructured the Treasurys investment since May 31, 2010, the date used as the basis for OMB's analysis.
Clearly, it was not apparent when the TARP was created two years ago that the cost would turn out to be this low. At that time, the U.S. financial system was in a precarious condition, and the transactions envisioned and ultimately undertaken through the TARP engendered substantial financial risk for the federal government. However, the cost has come out toward the low end of the range of possible outcomes anticipated when the program was launched. Because the financial system stabilized and then improved, the amount of funds used by the TARP was well below the $700 billion initially authorized, and the outcomes of most transactions made through the TARP were favorable for the federal government.
Federal Debt and the Risk of a Fiscal Crisis
July 27, 2010
Over the past few years, U.S. government debt held by the public has grown rapidlyto the point that, compared with the total output of the economy, it is now higher than it has ever been except during the period around World War II. The recent increase in debt has been the result of three sets of factors: an imbalance between federal revenues and spending that predates the recession and the recent turmoil in financial markets, sharply lower revenues and elevated spending that derive directly from those economic conditions, and the costs of various federal policies implemented in response to the conditions.
Further increases in federal debt relative to the nations output (gross domestic product, or GDP) almost certainly lie ahead if current policies remain in place. The aging of the population and rising costs for health care will push federal spending, measured as a percentage of GDP, well above the levels experienced in recent decades. Unless policymakers restrain the growth of spending, increase revenues significantly as a share of GDP, or adopt some combination of those two approaches, growing budget deficits will cause debt to rise to unsupportable levels.
Although deficits during or shortly after a recession generally hasten economic recovery, persistent deficits and continually mounting debt would have several negative economic consequences for the United States. Some of those consequences would arise gradually: A growing portion of peoples savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers; that crowding out of investment would lead to lower output and incomes than would otherwise occur. In addition, if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output. Rising interest costs might also force reductions in spending on important government programs. Moreover, rising debt would increasingly restrict the ability of policymakers to use fiscal policy to respond to unexpected challenges, such as economic downturns or international crises.
Beyond those gradual consequences, a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the governments ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates. It is possible that interest rates would rise gradually as investors confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis. But as other countries experiences show, it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply. The exact point at which such a crisis might occur for the United States is unknown, in part because the ratio of federal debt to GDP is climbing into unfamiliar territory and in part because the risk of a crisis is influenced by a number of other factors, including the governments long-term budget outlook, its near-term borrowing needs, and the health of the economy. When fiscal crises do occur, they often happen during an economic downturn, which amplifies the difficulties of adjusting fiscal policy in response.
If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation. To restore investors confidence, policymakers would probably need to enact spending cuts or tax increases more drastic and painful than those that would have been necessary had the adjustments come sooner.
The Budgetary Impact and Subsidy Costs of the Federal Reserve's Actions During the Financial Crisis
May 24, 2010
Over the past several years, the nation has experienced its most severe financial crisis since the Great Depression of the 1930s. In response, policymakers undertook a series of extraordinary actions to stabilize financial markets and institutions. The Federal Reserve System used its traditional policy tools to reduce short-term interest rates and increase the availability of funds to banks, and it created a variety of nontraditional credit programs to help restore liquidity and confidence to the financial sector. In doing so, it more than doubled the size of its asset portfolio to over $2 trillion and assumed more risk of losses than it normally takes on.
The financial system plays a vital role in the U.S. economy. It channels funds from savers to businesses, households, and governments that need money to finance investments and other expenditures, and it provides services that are essential for commercial and financial transactions. When the financial system is functioning smoothly, investors trade securities in liquid markets that provide reliable signals about the values of assets, and loans are readily available to creditworthy borrowers. As the nation's central bank, the Federal Reserve System plays an important role in maintaining the stability and liquidity of the financial system through its conduct of monetary policy and its authority as a supervisor and regulator of banking institutions.
Over the past several years, the nation has experienced its most severe financial crisis since the Great Depression of the 1930s. Unexpected losses on subprime mortgages (loans made to borrowers with poorer-than-average credit) as well as heightened uncertainty about how exposed some financial institutions might be to additional losses led to a sharp decline in the liquidity of some markets and the availability of credit. The contraction in lending became more severe as the turmoil spread beyond the subprime mortgage market, several large financial institutions failed, and the economy weakened. Net lending by the private financial sector fell from more than $3.0 trillion in 2007 to annual rates of about $1.4 trillion in the fourth quarter of 2008 and -$1.8 trillion in the first quarter of 2009.
In response to that contraction, the Federal Reserve undertook a series of extraordinary actions to stabilize financial markets and institutions. It continued to use its traditional monetary policy tools, but in addition, it created a variety of targeted credit programs to help restore liquidity and confidence to the financial sector. Its actions included:
- Expanding lending to depository institutions-that is, to financial institutions, such as commercial banks and savings and loan associations, whose liabilities largely consist of checking and savings accounts and other deposits;
- Creating new lending programs, or "facilities," for nondepository financial institutions and other participants in the financial markets;
- Purchasing mortgage-related securities and medium and long-term securities of the U.S. Treasury in the open market to put downward pressure on medium and long-term interest rates in the mortgage and debt markets; and
- Extending support to financial institutions whose failures policymakers believed could lead to a systemic collapse of financial markets and institutions.
In effect, the Federal Reserve assumed some of the credit- providing functions that participants in the financial markets were unable or unwilling to perform. In doing so, it also assumed significantly more risk of incurring losses than it normally takes on in its operations.
The Federal Reserve's activities during the crisis have had a striking impact on the amount and types of assets that it holds (see Summary Figure 1). In July 2007, before the financial crisis began, the Federal Reserve held about $900 billion in assets; U.S. Treasury securities accounted for about $790 billion of that amount. The central bank had acquired those securities during its normal operations in conducting monetary policy-the process of influencing the level of short-term interest rates and consequently the pace of U.S. economic activity. (Box 2 on page 6 outlines the basic mechanics of monetary policy.) By the end of 2008, the value of the Federal Reserve's assets had grown to about $2,275 billion; of that amount, loans and other support extended to financial institutions made up $1,686 billion. At the end of 2009, when the turmoil in the financial markets had subsided, the total value of the central bank's assets remained essentially where it was at the end of 2008. The amount of direct loans and other support to financial institutions, though still quite high by historical standards, had fallen markedly by the end of 2009, to about $280 billion, but holdings of mortgagerelated securities had risen, to just over $1,000 billion.
The Federal Reserve's activities during the crisis have also led to a marked shift in the composition of the central bank's liabilities (see Summary Figure 2). Before the crisis, the major liability on the Federal Reserve's balance sheet was the amount of currency (Federal Reserve notes) in circulation- about $814 billion as of July 2007. At the end of 2009, the amount of reserves that banks held with the Federal Reserve was the central bank's largest liability. Such reserves have grown from about $6 billion at the end of July 2007 to more than $1,022 billion at the end of 2009; those reserves greatly exceed the amount that banks are required to hold. In effect, the Federal Reserve financed its activities during the crisis primarily by creating bank reserves rather than by issuing more currency or increasing its other liabilities.
The amount and composition of the central bank's assets and liabilities are major determinants of the Federal Reserve's impact on the federal budget. That impact is measured by the central bank's cash remittances to the Treasury, which are recorded as revenues in the budget. (The amount that is remitted is based on the Federal Reserve System's income from all of its various activities minus the costs of generating that income, dividend payments to banks that are members of the Federal Reserve System, and changes in the amount of the surplus that it holds on its books.) For fiscal years 2000 through 2008,annual remittances by the Federal Reserve ranged between $19 billion and $34 billion.
The Congressional Budget Office (CBO) projects that the Federal Reserve's actions to stabilize the financial system will boost its remittances to the Treasury during the next several years. That increase reflects the Federal Reserve's larger portfolio of assets, most of which are likely to earn a great deal more than the amount the system must pay in interest on reserves and its other liabilities. CBO projects that remittances will grow from about $34 billion in fiscal year 2009 to more than $70 billion in fiscal years 2010 and 2011.
Projections of the Federal Reserve's remittances to the Treasury over the next few years, however, are more uncertain than projections made in the past. The system's asset holdings are now riskier, exposing the central bank to a considerably greater possibility of losses than its usual holdings of Treasury securities do. Moreover, the risk of losses from default associated with the amounts of the remittances is asymmetric. The chances are great that the Federal Reserve will remit slightly more than the amounts CBO expects. But there is also a small chance that it will remit much less-or even nothing-if serious problems reemerge in the financial markets or the economy greatly weakens again.
Measuring the impact of the Federal Reserve System's actions by the magnitude of its cash remittances to the Treasury fails to account for the cost of the risks to taxpayers from those actions. When the Federal Reserve invests in a risky security, it increases its expected net earnings because the return it anticipates on that security exceeds the interest rate it pays on the debt used to fund the purchase. If the Federal Reserve purchases the security at a fair market price, equivalent to what private investors would have paid, then the purchase creates no economic gain or loss for taxpayers; the price compensates the central bank for the risk it has assumed. By contrast, if the Federal Reserve purchases a risky security for more than the amount that private investors would have paid, it gives a subsidy to the seller of the security, creating an economic loss, or cost, for taxpayers.
The economic cost of the Federal Reserve System's actions to stabilize the financial markets-which incorporates the risks to taxpayers-can be estimated using "fair-value" subsidies. Fair value in many instances corresponds to market value; it is defined as the price that would be received by selling an asset in an orderly transaction between market participants on a designated measurement date. Subsidies estimated on a fair-value basis provide a more comprehensive measure of cost than do estimates made on a cash basis: They take into account the discounted value of all future cash flows associated with a credit obligation, and they include the cost of bearing risk. CBO and the Administration's Office of Management and Budget (OMB) use a conceptually similar subsidy measure, as specified by the Emergency Economic Stabilization Act of 2008, to estimate the budgetary cost of the Troubled Asset Relief Program, or TARP. (CBO calls such subsidies "fair value" in part to distinguish them from subsidies calculated through the method specified by the Federal Credit Reform Act of 1990 and used by CBO and OMB to estimate the budgetary cost of federal credit programs.)
In CBO's estimation, the fair-value subsidies conferred by the Federal Reserve System's actions to stabilize the financial markets totaled about $21 billion (see Summary Table 1 for details). The subsidies are estimated as of the date of inception of the main programs that the central bank put in place-when the major economic commitments occurred-and they incorporate CBO's projections of all future cash flows over the life of those facilities, the uncertainty surrounding the flows, and the expected rate of return that investors would have required for taking on the same obligations. The gains or losses that will ultimately be realized from the Federal Reserve's activities will almost certainly deviate from CBO's estimates of the fair-value subsidies those actions provided. Such forward-looking estimates are based on averages over many possible future outcomes, whereas realized gains or losses reflect a particular outcome.
In total, the fair-value subsidies that CBO has estimated are modest when compared, for instance, with CBO's estimate of the $189 billion subsidy provided by the TARP at its inception-even though most of the central bank's facilities were introduced near the height of the crisis, when the price of risk was substantial and the probability of default was elevated. The subsidies' relatively small magnitude reflects the fact that the Federal Reserve's potential for losses was limited in most instances by requirements for borrowers to provide collateral, by guarantees from the Treasury under the TARP and from the Federal Deposit Insurance Corporation, or by various restrictions on the programs. Furthermore, some of the assistance that the Federal Reserve provided involved no subsidies because the transactions were conducted on a fair-value basis or at prices determined in competitive auctions-meaning that the central bank was fully compensated for the risks it assumed.
CBO's estimates of the economic subsidies that the Federal Reserve has provided are highly uncertain. The estimates necessarily rely on judgments about the probability that the crisis would have deepened or abated, about the sums that might be borrowed and their associated interest rates at such times, and about the severity of losses. Uncertainty also surrounds the discount rates used in CBO's calculations, but that effect is mitigated by the short time over which most of the facilities were scheduled to operate. Indeed, most programs have already been ended.
It bears emphasizing that CBO's fair-value estimates address the costs but not the benefits of the Federal Reserve's actions. In CBO's judgment, if the Federal Reserve had not strategically provided credit and enhanced liquidity, the financial crisis probably would have been deeper and more protracted and the damages to the rest of the economy more severe. Measuring the benefits of the Federal Reserve's interventions in avoiding those worse outcomes is much more difficult than estimating the subsidy costs of the interventions, and CBO has not attempted to do so. It is likely, though, that the benefits of the Federal Reserve’s actions to stabilize the financial system exceeded the relatively small costs reported here for fair-value subsidies.