Alan Greenspan: Regulatory reform of the government-sponsored enterprises
Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Committee on Banking, Housing and Urban Affairs, US Senate, 6 April 2005.
* * *
Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank you for again inviting me to
discuss the role of housing-related government-sponsored enterprises (GSEs) in our economy. As I
described at length last year, the Federal National Mortgage Association and the Federal Home Loan
Mortgage Corporation (hereafter Fannie and Freddie) have contributed importantly to the development
of the secondary home mortgage market and thereby to the diversification of funding sources for
depository institutions and other mortgage originators. In particular, Fannie and Freddie played a
critical role in promoting mortgage securitization - the key to the success of secondary mortgage
markets in the United States.1
The stated intent of the Congress is to use the housing-related GSEs to provide a well-established
channel between housing credit and the capital markets and, through this channel, to promote
homeownership, particularly among lower-income families. Although prospectuses for GSE debt are
required by law to say that such instruments are not backed by the full faith and credit of the U.S.
government, investors have concluded that the government will not allow GSEs to default, and as a
consequence offer to purchase GSE debt at substantially lower interest rates than required of
comparably situated financial institutions without such direct ties to government.2 Given this
advantage, which private competitors are not able to fully overcome, the housing-related GSEs have
grown rapidly in recent years.
The strong belief of investors in the implicit government backing of the GSEs does not by itself create
safety and soundness problems for the GSEs, but it does create systemic risks for the U.S. financial
system as the GSEs become very large. Systemic risks are difficult to address through the normal
course of financial institution regulation alone and, as I will stipulate shortly, can be effectively handled
in the case of the GSEs by limiting their investment portfolios funded by implicitly subsidized debt.
The government guarantee for GSE debt inferred by investors enables Fannie and Freddie to
profitably expand their portfolios of assets essentially without limit.3 Private investors have granted
them a market subsidy in the form of lower borrowing rates. Unlike subsidies explicitly mandated by
the Congress, the implicit subsides to the GSEs are incurred wholly at the discretion of the GSEs.
Because Fannie and Freddie can borrow at a subsidized rate, they have been able to pay banks,
thrifts, mortgage companies, and other home mortgage originators slightly higher prices for mortgages
than their potential competitors have paid. This edge has enabled Fannie and Freddie to gain
gradually but inexorably an ever-larger share of the home mortgage market. Investors have provided
Fannie and Freddie with a powerful vehicle for pursuing profits through the rapid growth of their
balance sheets, and the resultant scale has given them an advantage that their potential private-sector
competitors cannot meet.
But the higher prices that these two GSEs pay for mortgages are only a small part of their subsidy, as
evidenced by their persistent and well-above-market returns on equity capital. Their annual return on
equity, often exceeding 25 percent, is far in excess of the average approximately 15 percent annual
returns achievable by other large financial competitors holding substantially similar assets. Virtually
none of the GSE excess return reflects higher yields on assets; it is almost wholly attributable to
subsidized borrowing costs.
The ability of the GSEs to borrow essentially without limit has been exploited only in recent years. At
the end of 1990, for example, Fannie's and Freddie's combined portfolios amounted to $132 billion, or
5.6 percent of the single-family home-mortgage market. By 2003, the GSEs' portfolios had grown
tenfold, to $1.38 trillion or 23 percent of the home-mortgage market. The almost unlimited
low credit risk profit potential from exploiting subsidized debt has been available to the GSEs for
decades. The management of Fannie and Freddie, however, chose to abstain from making
profit-centers out of their portfolios in earlier years, and only during the mid-1990s did they begin
rapidly enlarging their portfolios.
Typically in a market system, lenders and investors monitor and discipline the activities, including
leverage, of their counterparties to assure themselves of the financial strength of those to whom they
lend. However, market discipline with respect to the GSEs has been weak to nonexistent. Because the
many counterparties in GSE transactions assess risk based almost wholly on the GSE's perceived
special relationship to the government rather than on the underlying soundness of the institutions,
regulators cannot rely on market discipline to contain systemic risk.
When these institutions were small, the potential for such risk, if any, was small. Regrettably, that is no
longer the case. From now on, limiting the potential for systemic risk will require the significant
strengthening of GSE regulation and the GSE regulator. Determining the suitable amount of capital for
Fannie and Freddie is a difficult and technical process, and in the Federal Reserve's judgment, a GSE
regulator must have as free a hand as a bank regulator in determining the minimum and risk-based
capital standards for these institutions.
Beyond strengthening GSE regulation, the Congress will need to clarify the circumstances under
which a GSE can become insolvent and, in particular, the resultant position - both during and after
insolvency - of the investors that hold GSE debt, as well as other creditors and shareholders. This
process must be unambiguous before it is needed. Current law, which contemplates conservatorship
and not receivership for a troubled GSE, requires the federal government to maintain GSEs as
ongoing enterprises, but other than the symbolic line of credit at the U.S. Treasury, provides no means
of financing to do so. Left unresolved, such uncertainties could threaten the stability of financial
markets.
***
World class regulation, by itself, may not be sufficient and, indeed, might even worsen the potential for
systemic risk if market participants inferred from such regulation that the government would be more
likely to back GSE debt in the event of financial stress. This is the heart of a dilemma in designing
regulation for GSEs.
On the one hand, stiffening their regulation might strengthen the market's view of GSEs as extensions
of government and their debt as government debt. The result, short of a very substantial increase in
equity capital, would be to expand the size of the implicit subsidy and allow the GSEs to play an
even-larger unconstrained and potentially destabilizing role in the financial markets.
On the other hand, if we fail to strengthen GSE regulation, we increase the possibility of insolvency
and crisis. We at the Federal Reserve believe this dilemma would be resolved by placing limits on the
GSEs' portfolios of assets, perhaps as a share of single-family home mortgages outstanding or some
other variation of such a ratio. Almost all the concerns associated with systemic risks flow from the
size of the balance sheets of the GSEs, not from their purchase of loans from home-mortgage
originators and the subsequent securitization of these mortgages.
We have been unable to find any purpose for the huge balance sheets of the GSEs, other than profit
creation through the exploitation of the market-granted subsidy. Some maintain that these large
portfolios create a buffer against crises in the mortgage market. But that notion suggests that the
spreads of home-mortgage interest rates against U.S. Treasuries, a measure of risk, would narrow as
GSE portfolios increased. Despite the huge increase in the GSE portfolios, however, mortgage
spreads have actually doubled since 1997, when comparable data for interest rate spreads on
mortgage-backed securities first became available.4
A recent study by Federal Reserve Board staff found no link between the size of the GSE portfolios
and mortgages rates.5 The past year provides yet more evidence, with GSE portfolios not growing and
mortgage spreads, as well as the spread between yields on GSE debentures and Treasury securities,
declining further. Indeed, while GSE stock prices have fallen substantially and turmoil has continued at
the GSEs, mortgage markets have functioned well.
Others have asserted that fixed-rate mortgages would be more difficult, or perhaps even impossible, to
obtain without the GSEs' portfolios. But, again, we see little empirical support for this argument. We
have found no evidence that fixed-rate mortgages, for example, were difficult to obtain during the early
1990s when GSE portfolios were small. Indeed, the share of adjustable-rate mortgage originations
averaged slightly more than 20 percent in 1992, when GSE portfolios were small, and averaged 34
percent in 2004, when GSE portfolios were large; these data suggest that the size of the GSEs'
portfolios is unrelated to the availability or popularity of fixed-rate mortgages. As far as we can tell,
GSE mortgage securitization, in contrast to the GSE's portfolio holdings, is the key ingredient to
maintaining and enhancing the benefits of the GSEs to homebuyers and secondary mortgage
markets. And mortgage securitization, unlike the GSE portfolio holdings, does not create substantial
systemic risks.
***
We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage
portfolios of the GSEs, which concentrate interest rate risk and prepayment risk at these two
institutions and makes our financial system dependent on their ability to manage these risks. Although
Fannie and Freddie have chosen not to expand their portfolios significantly this past year (presumably
at least partly in light of their recent difficulties), the potential for rapid growth in the future is not
constrained by the existing legislative and regulatory regime. It is a reasonable presumption that rapid
growth is likely to resume once Fannie and Freddie believe they have resolved their current
difficulties.6 Without changes in legislation, Fannie and Freddie will, at some point, again feel free to
multiply profitability through the issuance of subsidized debt. To fend off possible future systemic
difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are
required sooner rather than later.
Limiting the debt of Fannie and Freddie, while comparably expanding their role in mortgage
securitization, would be consistent with the original congressional intent that these institutions provide
stability to the secondary market for home mortgages and liquidity for mortgage investors. Indeed, in
1989, before the rapid expansion of its portfolio, Freddie testified before the Congress that the need
for safe and sound operation and provision of affordable mortgages to homebuyers was inconsistent
with holding a substantial portfolio. As argued by Freddie's CEO at that time, by financing mortgages
with mortgage-backed securities sold to investors, Freddie avoided interest rate risks and thus could
keep mortgages flowing when depository institutions were suffering an interest rate squeeze.7
Freddie's message changed after 1989 when it became owned by private shareholders and it began
to exploit the risk-adjusted profit-making potential of a larger portfolio.
***
The creation of mortgage-backed securities for public markets is the appropriate and effective domain
of the GSEs. Deep and liquid markets for mortgages are made using mortgage-backed securities that
are held solely by investors rather than the GSEs. Fannie's and Freddie's purchases of their own or
each other's mortgage-backed securities with their market-subsidized debt do not contribute usefully
to mortgage-market liquidity, to the enhancement of capital markets in the United States, or to the
lowering of mortgages rates for homeowners.
The bulk of the GSEs' portfolio growth over the past decade has occurred mainly through the
acquisition of their own mortgage-backed securities - which reflect the AAA-rating of pools of home
mortgages. As I indicated earlier, holding their own securities in portfolio often yielded Fannie and
Freddie subsidized annual returns on equity of more than 25 percent, far in excess of the returns to
purely private financial institutions from holding such securities.
***
Limiting the systemic risks associated with GSEs would require that their portfolio holdings be
significantly smaller. At the same time, reducing portfolios would have only a modest effect on financial
markets. Currently, these portfolios are financed largely by the issuance of GSE debt, which, in turn, is
held by investors.
If mortgage-backed securities were sold into the market or allowed to self-amortize - and accordingly
GSE debt was redeemed - the transaction from the point of view of the supply and demand for
high-quality credit is essentially a wash. In the simplest outcome, the holders of GSE debt would be
seen as exchanging their debt instruments for the mortgage-backed securities previously held on GSE
balance sheets.8 As for homebuyers, whether GSE mortgage purchases are held in GSE portfolios or
securitized and sold to investors appears to have no noticeable effect on mortgage rates.
Limitations on portfolio holdings could be imposed gradually over several years and then adjusted
upward or downward depending on the growth of the single-family mortgage market. Very short-term
Treasury holdings needed for liquidity and other assets employed for business operations could be
exempt from these limitations. Such a restriction would provide the GSEs with ample liquidity and
would focus the GSEs almost exclusively on the purchase and securitization of mortgages, including
mortgages for affordable housing. In other words, this restriction frees the GSEs of the difficulties of
hedging large-scale interest rate risk. I should note that, even with such portfolio limits, Fannie and
Freddie would likely remain among the most formidable of financial institutions in our country.
***
As I concluded last year, the GSEs need a regulator with authority on a par with banking regulators,
with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned
by the Congress for placing a GSE in receivership, where the conditions under which debt holders
take losses are made clear. However, if legislation takes only these actions and does not limit GSE
portfolios, we run the risk of solidifying investors' perceptions that the GSEs are instruments of the
government and that their debt is equivalent to government debt. The GSEs will have increased facility
to continue to grow faster than the overall home-mortgage market; indeed since their portfolios are not
constrained, by law, to exclusively home mortgages, GSEs can grow virtually without limit. Without
restrictions on the size of GSE balance sheets, we put at risk our ability to preserve safe and sound
financial markets in the United States, a key ingredient of support for homeownership.