Appendix 3 America's Housing Market

America's booming housing market, and the government-sponsored agencies that are financing it, may be the source of nasty economic problems ahead

House prices are notoriously cyclical. So it is fair to assume that the boom currently being experienced by America's housing market will not last forever. When the market does turn down, it will have the usual dampening effect on economic growth. In this cycle, however, there may be even more to worry about. A reversal in the housing market could have serious implications for the institutions whose lending has fuelled the boom. These include government-"sponsored" mortgage agencies such as Fannie Mae (the Federal National Mortgage Association), Freddie Mac (the Federal Home Loan Mortgage Corporation) and the Federal Home Loan bank system, which is mutually owned by thrifts. These institutions are increasingly important to the health of America's entire financial system.

The agencies have been increasing their lending at a 20% annual rate in the past couple of years, as, to rather less attention, has the Federal Home Loan system. The federal mortgage agencies already have combined debts of $1.4 trillion.

The financial markets may be allowing this to happen only because they believe, with some justification, that if things go wrong, the government will come to the rescue. Housing is a political minefield. Fannie and Freddie were fighting off complaints that they were lending too little, particularly to the poor and to ethnic minorities.

Nonetheless, it is the ballooning balance sheets, and the potential liabilities for the taxpayer, that are the most urgent focus of attention. Although they started life as fully public bodies - Fannie Mae in 1938, Freddie Mac in 1970 - they have since moved into a twilight zone between the public and private sectors. Shares in both are listed on the New York Stock Exchange. Both say they are genuinely private companies, which do not receive a penny from the government. Indeed, they are among the 50 most profitable American companies.

Yet they also enjoy benefits not available to any truly private firm, such as exemption from state and local taxes. They face less testing capital requirements than their private-sector rivals, allowing them to load on much higher levels of borrowing. Fannie and Freddie have roughly $32 of debt for each dollar of capital, compared with $11.50 of debt per dollar at large banks. Their implicit government guarantees allow them to borrow cheaply. And they have an emergency credit-line from the Treasury of $8.5 billion (so far unused). A third agency, the Government National Mortgage Association, known as Ginnie Mae, has an explicit guarantee, but is a much smaller organisation.

In 1996, various official reports looking at the case for a complete privatisation of Fannie and Freddie concluded that its quasi-public status represented a subsidy worth around $6 billion a year. According to the reports, as much as one-third of the subsidy is not passed on to mortgagees. Instead, it goes to shareholders and employees. Recently, Fannie's and Freddie's return on equity has averaged 24%, compared with 15-17% for private banks and securities firms. And pay is way above public-sector (and indeed most private-sector) rates.

At first, the federal mortgage agencies provided useful liquidity, making it easier for people to get a home loan. In the 1970s and 1980s they led the development of asset-backed securities markets, by selling bundles of mortgages, something none of America's then small mortgage banks could have dreamed of doing. Now, though, the financial markets are large and sophisticated enough to do without a federal helping hand.

So Fannie and Freddie may be doing more harm than good. They make mortgages slightly cheaper, while mostly stifling truly private competition (though currently they are making it easier for start-up Internet lenders to take on the established banks, prompting the banks to lobby harder against them). And they are expanding their range of activities. They are moving into "sub-prime" lending to less creditworthy borrowers. Some of the firms in that market reckon that the agencies' recent crusade against "predatory lending" in these markets is merely a figleaf to cover up their own predatory swoop.

A recent study by the American Enterprise Institute says that Fannie and Freddie are on course to "nationalise" the residential-mortgage market. Bert Ely, a co-author, reckons that their profit goals may lead them to expand into "jumbo" mortgages, above their current lending ceiling for individual mortgage loans, and even into commercial mortgages and small-business loans.

There are further reasons to worry. Fannie and Freddie's debt and securities are exempt from regulations that limit banks' exposure to the securities of any single private company. Currently, bank-held federal-agency securities and debt amount to one-third of total bank capital - a highly concentrated risk.

Fannie and Freddie may have fuelled an unsustainable credit bubble. The expansion of their balance sheets in the past two years represents massive credit-creation. Doug Noland of David Tice, a fund-management firm, reckons that their purchases of mortgage-backed securities during the financial crisis in autumn 1998 bailed out many troubled financial firms. Their continued expansion since then has pumped liquidity into the system when the Federal Reserve was trying to reduce it.

Precisely what their role has been is hard to measure, not least because they have been big participants in the less transparent corners of the derivatives markets. Nobody suggests the agencies are in any immediate danger. Fannie points out that defaults total only three cents for every $100 it lends. But, since they expanded so fast, the quality of their risk management has not been tested by a market downturn. Ominously, during the last housing bust in the 1980s, Fannie became technically insolvent, though regulators allowed it to "grow out of its difficulties".

The markets may be waking up to the risks. Ironically, the turning-point came earlier this year, when it was suggested that, as the supply of Treasury bonds dwindles thanks to the federal government's surplus, mortgage-agency debt could replace them as the benchmark used for pricing other fixed-income securities. Treasuries are guaranteed by the federal government, whereas Fannie's and Freddie's debt is not, at least in theory. Proposals for reform fall into two broad camps. One is to try to rein in the agencies, by keeping them to their narrow lending remit and imposing tougher capital requirements. The other, cleaner, approach would be to privatise them, so that the markets are left in no doubt that their debt carries no government guarantee, implicit or explicit. There is an encouraging precedent: in 1997 Sallie Mae, the student loans agency, was privatised by separating its government-guaranteed loans and debts from its future, non-guaranteed, activities. Expect Fannie and Freddie to pull all their influential political strings to stop it happening to them.

* "Nationalising Mortgage Risk. The Growth of Fannie Mae and Freddie Mac". By Peter Wallison and Bert Ely, AEI, 2000