What is Fannie good for? January 24, 2012 at 7:19 am

Papagianis and Swagel writing on Bloomberg view about Fannie Mae and Freddie Mac argue that the US government should

recognize budgetary reality and put the firms’ liabilities on the government balance sheet and include their spending in the federal budget.

They are probably right. I certainly think that if an entity enjoys a government guarantee on its debt, then it should be on the government’s balance sheet. Indeed, you could make an argument that Fannie and Freddie’s problems were at least partly due to having private shareholders (which in turn was a 1954 trick to keep them off balance sheet).

Anyway, let’s ignore whether Fannie and Freddie should exist, and assume that they do. What function can they perform?

You could argue as follows.

  1. A credit spread contains (at least) a liquidity premium, compensation for default, and a return on the equity needed to support unexpected risk.
  2. Non mark to market holders are only exposed to default risk, assuming they are well enough funded and capitalized to hold to term.
  3. Therefore, a non-mark-to-market government guaranteed player in the mortgage market does not need to make as a high a return as private capital and thus can charge less for mortgages.
  4. If you believe that home ownership is a societal good (something I do not intend to get in to here), then having such an entity would by extension be good too.
  5. But, seen in this light, it is really clear that government has the risk that the aggregate credit spread paid on mortgages is not sufficient to support experienced credit losses, and the profit if indeed the credit spread charged is more than sufficient. It is in the position of an equity investor as well as a debt guarantor (and so should consolidate).

What these entities do then – indeed what any mortgage insurer does – is attempt to monetize the difference between the spread you can charge on the mortgage and the compensation needed for default risk. This only works, of course, given that they do not need to mark their portfolios to market…

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