Interest only mortgage loan

The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation make mortgage markets inefficient, choke off competition, and help only the affluent.

Freddie Mac (the Federal Home Loan Mortgage Corporation) and Fannie Mae (the Federal National Mortgage Association) are two of the largest financial institutions in the nation, with more than half a trillion dollars in assets between them. Yet, few people can explain exactly what function these two financial giants serve. Their names are recognizable from the glowing discussions of their profitability in the financial section of the newspaper. They may sound familiar because of the commercials run nationwide that promote their foundations, generally focusing on Americans purchasing their first home. The ads do not discuss explicitly the role these financial institutions play regarding the home purchase, but they leave viewers with the warm and fuzzy feeling that, were it not for Freddie Mac and Fannie Mae, these people would not have been able to buy their first home.

Freddie Mac and Fannie Mae indirectly assist homebuyers by purchasing mortgages from lenders, such as commercial banks, savings and loans, and mortgage banks. Freddie Mac and Fannie Mae, in turn, generally get these loans off their books by creating securities (a process called securitization) that eventually are paid off as the underlying mortgages are paid off. So, homeowners are happy because they are aided in borrowing money for their home purchase. Lenders are happy because they don't have to hold on to mortgages for several years. Investors in the securities backed by mortgage payments are happy because they have a reliable investment product. Of course, Freddie Mac and Fannie Mae are happy because they make a handsome profit on the whole process. This sounds like capitalism at its finest, but the facts belie that rosy picture.

Although Freddie Mac and Fannie Mae are privately owned, they are government-sponsored enterprises (GSEs). This means they don't have to follow the same set of rules other privately owned companies do. They don't have to register their securities with the government; their securities receive special treatment for investment purposes; they don't have to pay state and local income taxes; and--most importantly--their government sponsorship gives them the aura of a fully guaranteed government entity. This final benefit means the markets think that, even though they are privately owned, the full faith and credit of the government stands behind the debt of these two enterprises--what is referred to as an implied or implicit guarantee. Thus, they save billions in borrowing costs, just as lenders are willing to offer low-interest student loans if they are guaranteed by the government. This savings alone allows the GSEs to pocket about $2,000,000,000 a year, according to estimates by the Congressional Budget Office (CBO) and Treasury Department, what some refer to as a blatant form of corporate welfare. So, it might be said that Freddie Mac and Fannie Mae are not pure capitalists, but, more precisely, "cafeteria capitalists"--they get to pick and choose between the best aspects of being a government corporation and the best aspects of being a private corporation.

Supposedly, the reason for granting all these benefits to Freddie Mac and Fannie Mae is that a fully private corporation could not survive without them. Only through government sponsorship could such entities be viable. Whether this argument was true 30 years ago, when the Congress set them up as privately owned corporations, such an argument is extremely suspect today, given the pace of innovation in the financial markets. For example, without the prodding or intervention of Congress creating a specialized government-sponsored enterprise, a secondary market for automobile loans has developed on its own in the private sector.

Having Congress grant special privileges to private companies in this manner is a bad idea. With these privileges granted to Freddie Mac and Fannie Mae, other potential competitors in their market are "crowded out" because they simply can not compete. It is no wonder that, with their many special benefits, they have no direct competition from private, non-sponsored entities, causing some to refer to them as a duopoly, a fancy term to indicate that these two GSEs share above-average profits in a noncompetitive market. Maintaining such a highly concentrated market could cause severe disruptions to the mortgage markets if either Freddie Mac or Fannie Mae were to fail. In comparison, the jumbo secondary market, so called because the loans purchased are larger than Congress allows the GSEs to purchase (about $225,000), is very fragmented and competitive.

Because funding costs for the GSEs are reduced through government sponsorship, some of that savings is passed on to homebuyers. Freddie Mac and Fannie Mae are not shy about touting this feature of government sponsorship. However, statistics show that the primary beneficiaries of these lower interest rates are not lower-income households, but middle- and upper-income ones. So, the GSE structure might be called a classic case of white middle- and upper-class welfare. Furthermore, the ultimate impact of this scheme is to draw funds into the middle- and upper-income housing sector at the expense of other sectors of the economy. Thus, lower interest rates in the housing sector are not a free lunch, as the GSEs claim, but are illusory because interest rates are raised in those other sectors. Congress should not give preference to one investment sector over another in this manner, but, instead, should do its best to level the playing field for all investments. This leaves it up to individuals to choose the investments that best suit their needs.

Freddie Mac and Fannie Mae have moved into new markets beyond their core function of purchasing high-quality mortgages to facilitate homeownership. Their rationale is simple. If the advantages of their status allow them to dominate the market for purchasing and securitizing home mortgages, they similarly should be able to dominate other markets. This squeezes out competitors who do not have the advantages of GSE status.

One example of entry into new markets is Freddie Mac's recent foray into subprime mortgages, which involves purchasing mortgages of riskier borrowers who have been late on paying monthly credit cards or other debt. Another is Fannie Mae's entrance into reverse mortgages. This product, primarily marketed to elderly homeowners, is the opposite of a normal mortgage, as the value of the home is drawn out by receipt of regular monthly payments. This is a useful product for those who need to draw out the equity from their homes, but really has nothing to do with the goal of assisting home ownership, as it targets those who already own their homes. The same thing can be said for the GSEs' entrance into the home equity market.

Increased risk

Not only are some of the activities of the GSEs beyond the function Congress originally had in mind for these enterprises, they reveal an added assumption of risk on the part of Freddie Mac and Fannie Mae. Certainly, the previous example of purchasing subprime mortgages is a growth in risk over purchasing high-quality mortgages. The GSEs increasingly are holding on to their mortgages, rather than securitizing them. When Freddie Mac and Fannie Mae do this, they have risk exposure that does not exist if the loans are securitized. They also have been purchasing loans with smaller down payments, sometimes as low as three percent. This means the borrower has less money at stake, leaving the GSEs with more at stake.

When it comes right down to it, though, why should anyone care about the riskiness of these activities? After all, these are privately owned companies, and if they start to lose money on their investments, the private shareholders will be the big losers. That is where the implicit guarantee comes in. If Congress is convinced that the failure of one of these financial giants would disrupt the mortgage markets, it ill-advisedly might choose to bail them out, benefiting any creditors who lend the GSEs money.

There is a precedent for the belief that, if a GSE fails, it will be the beneficiary of such a bailout. During the 1980s, the Farm Credit System, a GSE which focuses on agricultural credits, required billions of dollars in assistance during the systemic problems in the farm belt. As for the particular issue of whether one of the housing GSEs could fail, Fannie Mae actually was insolvent by $11,000,000,000 in the early 1980s, when the housing sector was going through similar systemic difficulties. Clearly, the possibility of the failure of a GSE is more than a theoretical notion.