Housing Giants Pose Risks: "The Hazard is that the firm will respond to these incentives by increasing risk to imprudent levels.".(Government Sponsored Enterprises)(Excerpt)

This is an excerpt from an article the three economists from the Federal Reserve Bank of St. Louis wrote for the Bank's quarterly publication, The Regional Economist. The full article about Fannie Mae, Freddie Mac and the Federal Home Loan Bank System can be found at www.stlouisfed.org.

All three housing GSEs obtain funding by selling debt instruments in the capital markets. Outstanding debt of the three GSEs at year-end 2003 exceeded $2.4 trillion, compared with publicly held debt of $4 trillion for the federal government. Because of the size of this outstanding debt, much of which is held by U.S. depository institutions, a loss of confidence in Freddie Mac, Fannie Mae or the FHLBanks could send shock waves through the financial system.

Therefore, the capital markets have concluded that the federal government most likely would not permit a default. This conclusion is not irrational. The federal government bailed out another government-sponsored enterprise, the Farm Credit System, in the 1980s.

Although circulars for housing-GSE debt warn that the instruments do not carry the full faith and credit of the U.S. government, the small yield spreads over comparable Treasury debt suggest that investors believe otherwise. Estimates of the value of the reduced funding costs vary.

One recent study concluded that it produced an average of a 40-basis-point (0.4 percent) reduction in the interest rate on Freddie and Fannie debt between 1998 and 2003.

In part because of implicit default guarantees, the housing GSEs have been extremely profitable in recent years. Fannie Mae earned net income of $7.9 billion during 2003, while Freddie Mac earned $10.1 billion during 2002 (latest year available) - sufficient to generate returns on equity well above 25% in each case.

The FHLBanks are cooperative institutions. Their profit figures are not as meaningful because part of the profit is distributed to members in the form of low-cost services. Bank and thrift membership in the FHLB System is growing, however, indicating that its owner-members find the combination of services and dividends quite valuable.