Fannie Mae and Freddie Mac need to be labeled as systemically important
The Senate Banking Committee held a hearing earlier this summer to explore whether Fannie Mae and Freddie Mac should be designated as systemically important financial institutions. Absolutely no one there, no witness and no senator, attempted to argue that they are not systemically important. That would be a hopeless argument indeed, since Fannie Mae and Freddie Mac guarantee half the credit risk of the giant United States housing finance sector and have combined assets of more than $5 trillion.
Fannie Mae is bigger than JPMorgan Chase and Bank of America, while Freddie Mac is bigger than Citigroup and Wells Fargo. They have already demonstrated that they can “pose a threat to the financial stability of the United States,” as the Dodd Frank Act has stated it. Are they systemically important? Of course. Are they financial companies? Of course. They are systemically important financial institutions, as a matter of simple fact.
This is true if you consider them as two of the largest and most highly leveraged financial institutions in the world, but it is equally true if you consider them as an activity that generates systemic risk. Guaranteeing half the credit risk of the biggest credit market in the world, second only to United States debt, is a systemically important and systemically risky activity. Leveraged real estate is, and has been throughout financial history, a key source of credit collapses and crises, as it was yet once again during the tumultuous period from 2007 to 2009. The activity of Fannie Mae and Freddie Mac is entirely about leveraging real estate. Moreover, they have been historically and still are very leveraged.
The Financial Stability Board stated that the “threatened failure” of a systemically important financial institution “puts pressure on public authorities to bail it out using public funds.” Fannie Mae and Freddie Mae displayed in their failure and still display the attributes of extremely large size, interconnectedness, complexity, cross border activity, and lack of substitutability. In 2008, federal authorities not only felt overwhelming pressure to bail them out, but they did in fact bail them out. In addition, they pledged the credit support from the Treasury that protected and continues to protect the global creditors of Fannie Mae and Freddie Mac, which remain utterly dependent on this credit support from the Treasury.
As Treasury Secretary Henry Paulson recounted in his memoir of the financial crisis, foreign investors held more than $1 trillion of the debt issued or guaranteed by the government sponsored entities, with major shares held in Japan, China, and Russia. He wrote, “They wanted to know if the United States would stand behind this implicit guarantee.” Paulson instructed his staff to “make sure that to the extent we can say it that the United States government is standing behind Fannie Mae and Freddie Mac.” He also memorably wrote, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”
Thanks to the bailout he directed, his assurances turned out to be true for all of the creditors of Fannie Mae and Freddie Mac. No reasonable person can dispute that Fannie Mae and Freddie Mac are systemically important financial institutions in reality. Yet so far, the Financial Stability Oversight Council has not designated them officially as such. Judging purely on the merits of the case, this is indefensible. Of course, Fannie Mae and Freddie Mac have an existing regulator in the Federal Housing Finance Agency. However, the Federal Housing Finance Agency is not, nor is it currently empowered to be, a regulator of the systemic risk created by government sponsored entities for the banking and financial system in its entirety.
Fannie Mae and Freddie Mac are by definition 100 percent concentrated in the risks of leveraged real estate. A matching systemic risk is that their regulator is likewise devoted only to housing finance. Such an agency is always pushed by powerful political forces to become a cheerleader for housing credit. This brought down the old Federal Home Loan Bank Board, abolished in 1989, and the Office of Thrift Supervision, abolished in 2010. It is relatively easy to picture a future Federal Housing Finance Agency, under the appointments of a future administration, behaving similarly in that perpetual fount of having systemic risk in leveraged real estate.
Therefore, designating both Fannie Mae and Freddie Mac as systemically important financial institutions cannot be delayed because they are in regulatory conservatorship. They are just as systemically important in conservatorship as out of it. The answer to the excellent question posed by the Senate Banking Committee earlier this summer is that it is high time to recognize reality and designate Fannie Mae and Freddie Mac as the systemically important financial institutions they so obviously are.
Alex Pollock is a distinguished senior fellow at the R Street Institute and the author of “Finance and Philosophy: Why We Are Always Surprised.” He has recently testified at the Senate Banking Committee hearing on this issue.
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