The privatization of Fannie Mae

Fannie Mae's recent $11 billion accounting scandal drew headlines, but even before that, critics, analysts and academics have urged that the time has come for this Government Sponsored Enterprise (GSE) to be completely privatized. Herbert Kaufman, a finance professor at the W. P. Carey School of Business who has been studying GSEs for many years, is among those who argue for privatization. By the 1980s the GSEs had served an important purpose in integrating the mortgage markets into the capital markets, Kaufman says, but at that point they should have been privatized. The issue, he continues, is the government's possible contingent liability in case of default.

Fannie Mae, the nation's top financer and guarantor of home mortgages, has been in the news since its $11 billion accounting scandal — including alleged manipulation of earnings to trigger executives' bonuses — was reported in September 2004. But even before that, critics, analysts and academics have urged that Fannie Mae be completely privatized.

Among those privatization advocates is Herbert Kaufman, professor of finance at the W. P. Carey School of Business, who has been studying the situation for decades. As a Government Sponsored Enterprise (GSE), the Federal National Mortgage Association (Fannie Mae) was chartered by Congress in 1938.

Fannie Mae created a secondary market for home mortgages operating under federal control, giving low- and moderate-income families access to mortgage credit — even in underserved neighborhoods. Although 1968 privatization legislation made Fannie Mae a shareholder-owned company traded on the New York Stock Exchange, it retained its exemption from state and local taxes (except property taxes).

The GSE also retained conditional access to a line of credit from the U.S. Treasury Department. (The Federal Home Loan Mortgage Corporation, known as Freddie Mac, is a similar private company, federally chartered in 1970, which can purchase mortgages and related securities, and then issue securities and bonds in financial markets backed by those mortgages in secondary markets.)

Although the securities that the GSEs guarantee and the debt instruments they issue are not explicitly backed by the full faith and credit of the federal government, they trade at yields only a few basis points over those of U.S. Treasury securities, based on the belief of many investors that the government would intervene if a GSE became insolvent. So GSEs operate at lower costs than other private firms. Kaufman believes such implicit backing should be eliminated to reduce the risk to taxpayers.

In a recent question-and-answer exchange, Kaufman outlined his views.

K@WPC: Do you support privatization of Fannie Mae? What about other GSEs?

Kaufman: Yes, for both mortgage market GSEs. Fannie and Freddie.

K@WPC: Were those GSEs a mistake in the first place?

Kaufman: No. They served an important purpose in integrating the mortgage markets into the capital markets. By the mid-'80s it is clear that they had very well accomplished that, and my view is they should have been fully privatized then, or at least the process should have begun. Remember that they are privately owned, but the implicit government guarantee umbrella is over them, or at least the market believes that and so do I.

K@WPC: Is there reason to question the implicit government guarantee umbrella? Why has it not been explicit?

Kaufman: It's not explicit, because unlike Treasury debt, it doesn't have the full faith and credit guarantee of the government. Nevertheless, the markets have interpreted it as having an implicit guarantee against default, as shown by the borrowing rates of GSEs being only a bit higher than Treasuries and much below that of the highest-rated corporations. In short, the market believes, and rightly I think, that the government would not allow a default.

This means that the government has a possible contingent liability in case of default of about $2 trillion, though that likely wouldn't be the actual number in case of default since clearly they have assets. Nevertheless the liability is substantial. When the GSEs were made government-chartered but privately owned, the explicit guarantee went away but there's no reason to question the implicit guarantee as long as they remain government-chartered and have other favorable legislative preferences.

K@WPC: What effect, if any, would privatization have on borrowing rates?

Kaufman: My guess is that it would move those rates to about equivalent to a double A rated corporation or perhaps even a single A. Note this is on debt to finance portfolio. The GSEs securitize more than half the mortgages, and the value of the guarantee that is removed would drive these rates up but how much is hard to say — too many variables.

K@WPC: What would the range of effect be on an average home mortgage borrower?

Kaufman: Hard to answer. There is a literature on how much of the subsidy that GSEs get goes to the mortgage market (best guess about half) and how much to stockholders and of course to compensation of management, a major issue these days. Anyway, it is fair to say that some of the subsidy goes to the market but much less than the subsidy actually given the GSEs. What the equilibrium result would be is hard to know because if the GSEs are privatized they would suddenly face much more competition for the mortgage products that they offer than they currently do.

Basically, they don't face any for their major products. With competition usually comes lower prices, so the net might be no impact on the mortgage market, though even if the loss of subsidy increases rates slightly in equilibrium — and I believe it would be slight at worst — it would be worth it to take the government out of the guarantee business.

K@WPC: You said GSEs have "served an important purpose in integrating the mortgage markets into the capital markets." Why was that important?

Kaufman: It brought much-needed liquidity to the mortgage market by essentially making mortgage financing available from the general capital markets rather than simply from financial intermediaries. There is no question that this increased liquidity was a major step forward in providing the underpinning to housing-market growth and home ownership. My point is that, at this time, this liquidity and access to the capital markets won't go away if the GSEs lose their government-sponsored status.

K@WPC: What would the timetable be for privatization, and how would it work?

Kaufman: Clearly there would need to be substantial time for a transition and much work on how it would be done. Legislation would have to be drafted and then implemented. I would guess we are talking about a three-to-five-year period for legislation to be passed and fully implemented so as to keep any temporary disruptions to a minimum and to allow for competitive programs by private institutions to be put into place.

Remember, we are not talking about eliminating the GSEs, just taking the implicit guarantee through the charter and small line of credit to the Treasury which reinforces this interpretation. The Boards of Directors, which now include directors nominated by the president, would also have to be totally privatized. All these moves would convince the market that the government is really out of the business of guaranteeing GSEs.

K@WPC: So a major selling point in getting legislation passed would be the benefits of more competitive programs?

Kaufman: Part of it. but the major draw for legislation is getting the government out of the contingent-liability situation when they no longer serve a necessary public purpose, though there would still be some issues in case of failure, even as private institutions, because of their size. Part of the transition might be to reduce the size of these GSEs in terms of what they could hold in portfolio. There is some movement in that direction now but only in the talking stage. The sell would be that, not more competition, but the latter is still important.

K@WPC: To the extent there has been privatization of government services, has it been of benefit to the average taxpayer and consumer? Or is the extent of it too insignificant to make a judgment?

Kaufman: Remember the argument about the privatization of GSEs is not based on the efficiencies gained, although I expect them, but on the contingent-liability issue for no return to the government in terms of public purpose. Basically the issue is: Is the cost and potential cost worth it? Also remember the GSEs also are privately owned unlike truly government-owned entities that are then privatized, so comparisons are difficult. However, competition does breed efficiencies and I do expect those from full privatization.

Bottom Line:

• Fannie Mae created a secondary market for home mortgages operating under federal control, giving low- and moderate-income families access to mortgage credit.
• Privatization legislation passed in 1968 made Fannie Mae a shareholder-owned company traded on the New York Stock Exchange, however it retained its exemption from state and local taxes (except property taxes) and retained conditional access to a line of credit from the U.S. Treasury Department.
• Many investors believe that the government would intervene if a GSE became insolvent even though the securities that the GSEs guarantee and the debt instruments they issue are not explicitly backed by the full faith and credit of the federal government.