(This is Part 1 of a two-part series. See Part 2: New operating models proposed for Fannie Mae.)

“The media has been full of stories recently about accounting scandals at Fannie Mae. Is this another Enron? What does it mean to John Q. Public?”

It is an accounting scandal, and heads have rolled as a result, but it is not another Enron.

The phony accounting at Enron concealed massive losses whereas the phony accounting at Fannie Mae concealed large fluctuations in income. Absent the phony accounting, Enron was insolvent, but Fannie remains solvent and very strong, if not quite as strong as it had appeared earlier.

Yet there is more at stake in the Fannie case because Fannie Mae is a “government-sponsored enterprise.” While Fannie and its smaller sister agency Freddie Mac have private shareholders and their employees are not under civil service, they enjoy important government supports. These include a line of credit with the Treasury Department and use of the facilities of the Federal Reserve.

For this and other reasons, the market believes that the federal government implicitly guarantees the obligations issued by Fannie and Freddie, so they can raise funds at a lower cost than any private firm. This cost advantage results in market dominance. No strictly private firm can compete with them in purchasing and reselling “conforming” mortgages that meet their requirements.

The flap about accounting has had one favorable consequence: Questions about the unique role of Fannie and Freddie in the U.S. housing finance system are now being actively discussed. Your question about the impact on John Q Public provides a useful way to get at these questions, but we must distinguish John Q. as borrower, taxpayer and citizen.

John Q as Borrower: Fannie Mae and Freddie Mac reduce the costs of borrowers who meet the underwriting requirements of the agencies, and who need loans no larger than the largest mortgage the agencies are allowed by law to purchase. For 2005 the maximum is $359,650. It is raised every year in line with increases in home prices.

To determine the size of this benefit, on Nov. 1, 2004, I shopped for 15-year and 30-year mortgages of $320,00 and $350,000, which were otherwise identical. Since only the smaller loan was eligible for sale to the agencies – the maximum loan in 2004 was $333,700 – the price difference between them is entirely attributable to the difference in eligibility.

After adjusting for small differences in upfront fees, I found that the rates on the smaller mortgage generally ranged from .25 percent to .375 percent lower than the rates on the larger mortgage. This amounts to payment reductions of 1.7 percent to 2.5 percent on 15-year loans, and 2.7 percent to 4.1 percent on 30-year loans.

These are not trivial differences, but they are not dramatic either. Market rates often change by this amount or more without attracting a great deal of attention.

In addition to reducing interest rates in a sizeable segment of the market, Fannie and Freddie have been required by Congress to target borrowers with low-to-moderate incomes, and/or residing in underserved areas. Every year, the Department of Housing and Urban Development (HUD) sets a target for the percent of the agencies’ mortgage purchases that ought to be accounted for by targeted borrowers. How many of these loans would not be made without the agencies’ support, however, is never clear.

John Q as Taxpayer: While John Q as borrower benefits from Fannie and Freddie, John Q as taxpayer could end up paying the bill.

The agencies reduce interest rates on the mortgages they purchase because they can raise the funds they need at costs only marginally higher than those paid by the U.S. Treasury, and well below the cost of funds to any AAA-rated private corporation. The reason for the low cost is that investors believe that Fannie and Freddie have a special claim for government assistance in the event they ever get into financial trouble.

This perception is well founded. Since the failure of the agencies to meet their obligations would be catastrophic, there is no doubt that government would step in to prevent it. If that were to happen, you and I would be on the hook for the cost. Taxpayers paid for the savings and loan debacle of the ’80s, and this one could cost even more. Different views on how this is best prevented will be discussed next week.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


What’s your opinion? Send your Letter to the Editor to opinion@inman.com.

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