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Freddie Mac, Fannie Mae Provide Even Greater Benefits to Homeowners and the Economy, Updated Study Finds
James C. Miller, III, the former Reagan administration official, discusses his recent findings that Freddie Mac and Fannie Mae pose small and manageable risks and provide even greater benefits to homeowners and the economy than previously reported. Q: You and your co-author James Pearce recently updated your study from 2001 that found Freddie Mac and Fannie Mae provide a net benefit to the nation in the form of lower interest rates on home mortgages. Can you briefly summarize your findings? Miller: For our January 2001 report, Freddie Mac had asked us to perform an analysis of the housing government-sponsored enterprises (GSEs) to determine whether they provide a net benefit to our nation. We estimated the size of the funding advantage the GSEs have in the capital markets and how much they lower interest rates that homeowners pay on their mortgages. And this analysis showed that the benefits borrowers received in lower interest costs substantially exceeded the benefits the GSEs received from their funding advantage, by at least $1.4 billion per year. We applied the same analysis for 2005, while updating our range of estimates to incorporate the latest research and market data. We found the aggregate amount of the funding advantage in 2005 ranged from $4.7 billion to $13.1 billion. But in 2005, borrowers saved between $16.2 and $20.7 billion in mortgage interest costs because of the GSEs. So the net benefit of the GSEs was between $3.1 billion and $16.0 billion per year. And note that even under the “worst case” estimate – assuming the highest funding advantage and the lowest interest savings estimates – the GSEs still provided a net benefit of at least $3.1 billion per year. This is more than double the “worst case” estimate for 2000. In reality, the actual net benefit probably was much higher, as the estimate ranges show. Keep in mind that this analysis looked only at lower mortgage rates – only one benefit the GSEs provide. It does not include other benefits they provide, such as a stabilizing force in the mortgage market, so in reality the net benefit of the GSEs is far greater than is captured in these numbers. Q: Economists at the Federal Reserve have published a study that concludes the GSEs have virtually no impact on mortgage rates. Your study obviously contradicts their conclusion. Who’s right? Miller: The study by the Fed economists produces estimates that are what researchers call “outliers” – they are substantially below the range of estimates produced not only by our work but also from quite a few other independent researchers. The reasons have to do with the economic model and the data the Fed economists use, which we and other economists believe generate estimates that are way too low. We provide a comprehensive review of the research on the GSEs’ effect on mortgage rates in the appendix of the new report. But ultimately it is not very hard to confirm that the GSEs lower mortgage rates. All you have to do is open up the Saturday real estate section of your newspaper and compare the rates lenders are offering for conforming loans GSEs buy versus the jumbo loans the GSEs cannot buy. You will see up to a one-half percentage point difference in rates. These rate differences aren’t theoretical – they exist, and they are what real people are paying in the real world. Q: What benefits do Freddie Mac and Fannie Mae provide beyond lowering mortgage rates? Miller: We identify several additional benefits in our study. Conforming loans – those the GSEs can buy – are more likely than jumbo loans to have low down payments and fixed rates. This reflects the greater ability and willingness of the GSEs to accept and manage the risks of low down payment, fixed-rate mortgages. Lower down payments make it possible for more people to own homes, and fixed rates protect homeowners from interest-rate risks. These benefits, along with the interest savings, induce many borrowers to take out conforming loans instead of jumbos. The GSEs also help stabilize the economy by stabilizing the housing market. Historically, home building and mortgage lending have been “procyclical” – they rise when the economy rises and fall when the economy falls. Because housing is an important part of the economy, these fluctuations in the market historically have accentuated economic booms and busts. But because the GSEs provide steady liquidity to the market and stabilize the market by serving as the buyers of last resort, the housing and mortgage markets have become much less volatile, and this has had stabilizing effects on the overall economy. In fact, housing was the strongest sector of the economy for several years and is widely credited with reducing the length and severity of the recession in 2001. The prevalence of fixed rate mortgages in the U.S. – which, again, the GSEs make possible – also helps stabilize our economy by shielding homeowners from the impact of rising interest rates. An interesting comparison is the United Kingdom, where most mortgages are adjustable rate. A recent study done for the British government found that the shock of interest rate increases on borrowers affects the overall economy. It determined that the U.K. housing market and the economy would be more stable if there were more fixed-rate mortgages. And of course the GSEs help increase homeownership in our nation, especially for minorities and underserved groups, through their secondary market activities. We discuss in our report research on the GSEs’ contributions to homeownership, as well as the many social benefits of increased homeownership. So in our view, the GSEs bring some very substantial net benefits to our nation. Q: Your study also examines the risks of the GSEs’ retained mortgage portfolios. What were your conclusions? Miller: We examined the argument that GSE portfolios pose a substantial systemic risk to the overall financial system and thus should be capped or even substantially reduced. After reviewing the latest research, as well as the disclosures the GSEs provide on their risk management, we concluded that the risks posed by the portfolios are not very large, and they certainly are manageable. Now of course, investing in mortgages poses risks, and these risks have to be managed well. But the GSEs do a very good job of both managing and disclosing these risks. And I believe the GSEs’ critics are too quick to discount or ignore the effectiveness and stringency of the capital standards and regulatory oversight of the GSEs. The risk-based capital standard that applies to the GSEs is very sensitive to the risks of their business – you increase risk, and the amount of capital required increases as well. When I was chairman of the CapAnalysis Group in 2003, we applied the GSE risk-based standard to the thrift industry and found that while the GSEs passed it, the thrift industry failed. So clearly it is a strong requirement, and the fact that the GSEs pass it suggests that they are not very likely to fail. OFHEO [the Office of Federal Housing Enterprise Oversight] also has demonstrated its ability to take strong supervisory action during the past few years. For these reasons, I’m convinced that the likelihood of the GSEs defaulting on their obligations is no greater than that of banks or other large financial institutions – if anything, the GSEs probably pose a smaller risk of default. Q: What were your conclusions regarding the benefits that GSE provide by investing in mortgages? Miller: The GSEs’ investment in mortgages and mortgage-backed securities benefits the housing finance system in several ways. They add liquidity to the market by purchasing mortgage assets on an ongoing basis. They provide stability by serving the market when other investors pull out – we saw this during the 1998 crisis caused by the collapse of Long Term Capital Management and in the aftermath of 9/11. And the GSEs expand the investor base for the housing system by issuing debt securities to fund their mortgage investments. Many investors don’t want to manage the market and prepayment risks of mortgage-backed securities, but these investors are more likely to purchase GSE debt securities, which are much more easily manageable investments. All of these benefits ensure that the mortgage market has the capital it needs at reasonable prices. Q: So you don’t think it makes sense to place limits on the size of GSE portfolios? Miller: Because the risks posed by the GSEs’ portfolios are modest, you would not get much additional reduction in risk from capping or reducing them. But you would limit – maybe substantially – the benefits of GSE mortgage investment. And as a matter of policy, I think it would be a bad idea to impose limits of this type on any financial institution without regard to how well it manages risk. So I believe policymakers should look critically at any proposal to legislatively curtail GSE mortgage investments. James C. Miller III served as Director of the Office of Management and Budget and Chairman of the Federal Trade Commission under President Ronald Reagan. Today he is a senior fellow at the Hoover Institution and George Mason University, chairman emeritus of Cap Analysis LLC, a senior advisor to Blackwell Sanders Peper Martin LLC, and a consultant to Freddie Mac. November 27, 2006 NEW Read the 2006 report, Revisiting the Net Benefits of Freddie Mac and Fannie Mae
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