The government triangle at the heart of U.S. housing finance
Published by Housing Finance International.
The U.S. central bank’s great 21st century monetization of residential mortgages, with $2.7 trillion of mortgage securities on the books of the Federal Reserve, is a fundamental expansion of the role of the government in the American housing finance system.
In Economics in One Lesson (1946), Henry Hazlitt gave a classic description of those whose private interests are served by government policies carried out at the expense of everybody else. “The group that would benefit by such policies,” Hazlitt wrote, “having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case,” with “endless pleadings of self-interest.”
Such pleadings have characterized the U.S. housing and mortgage lending industries over many decades, in Hazlitt’s day and in ours, with notable success, and resulted in the massive involvement and interventions of the U.S. government in housing finance. Through Fannie Mae, Freddie Mac and Ginnie Mae, the U.S. government guarantees about $8 trillion of mortgage debt. That’s $8 trillion. This sum is about 70% of the $11 trillion of mortgages in the country. Does it make sense for the U.S. government to guarantee 70% of the whole market? It does not. But so it has evolved in the politics of U.S. housing.
As part of this evolution, U.S. mortgage finance has become dominated by a tightly linked government triangle. The first leg of the triangle is composed of Fannie, Freddie and Ginnie (with its associated Federal Housing Administration). This leg we may call the Government Housing Complex.
The second leg in the government mortgage triangle is the United States Treasury. The Treasury is fully liable for all the obligations of the 100% government-owned Ginnie. The Treasury is also the majority owner of both Fannie and Freddie and effectively guarantees all their obligations, too. Through clever financial lawyering, it is not a legal guarantee, however, because that would require the honest inclusion of all Fannie and Freddie’s debt in the calculation of the total U.S. government debt. Unsurprisingly, this is not politically desired.
The same politically undesired, but honest, accounting result would follow if, on top of owning 100% of Fannie and Freddie’s $270 billion of senior preferred stock, the Treasury controlled 80% of their common stock. Government accounting rules require that at 80% the entity's debt must be consolidated into the government debt. That is why Treasury controls 79.9%, not 80%, of their common stock, which is done through warrants with an exercise price that rounds to zero. This is historically consistent, since to get Fannie’s debt off the government’s books was the main reason for its 1968 restructuring it into a so-called “government-sponsored enterprise,” so that President Lyndon Johnson’s federal deficit did not look as big.
The Federal Reserve didn’t used to be, but it has become the third leg of the government mortgage triangle, as the single biggest funder of mortgages by far. Its $2.7 trillion of mortgage securities holdings are limited to those guaranteed by Fannie, Freddie and Ginnie. But those guarantees are only credible because they are in turn backed by the credit of the Treasury.
However, there is another curious circle here. How can the Treasury, which runs huge continuing deficits and runs up its debt year after year, be thought such a good credit? It turns out that an essential support of the credit of the Treasury is the readiness of the Federal Reserve always to buy government debt by printing up the money to do so. This is why having a fiat currency central bank of its own is so very useful to any government. The intertwined credit of the Treasury and of the Federal Reserve are intriguingly dependent on each other, and they both support the credit of the government mortgage complex of Fannie, Freddie and Ginnie.
In this sense, it is helpful to think of the Federal Reserve and the Treasury as one thing – one combined government financing operation, whose financial statements should be consolidated. In such consolidated statements, the $5.8 trillion of Treasury debt owned by the Federal Reserve would be a consolidating elimination. With this approach, we could see the reality more clearly. The Federal Reserve buys and monetizes Treasury debt. Consolidate the statements. The Treasury bonds disappear. What is really happening? The consolidated government prints up money and spends it. In order to spend, it is taxing by monetary inflation, without the need to vote on taxes and without the need for the legislature to act at all.
We should then bring Fannie, Freddie and Ginnie into the consolidation. The government mortgage complex issues mortgage securities, then the Federal Reserve buys and monetizes them. Consolidate the statements, and the mortgage securities held by the Federal Reserve also disappear as a consolidating elimination. What reality is left? The consolidated government prints up “free” money and uses it to make mortgage loans, inflating the price of houses. This arrangement suits housing lobbyists, to be sure, and the proponents of “modern monetary theory” who wish to have no limits on the government’s ability to spend. Of course, this theory is an illusion. The reality, and the most fundamental of all economic principles is: Nothing is free. Free printed money becomes very expensive indeed when it turns into destructive inflation.
In principle, a fiat currency central bank can buy and monetize not just bonds and mortgages, but any asset. For example, the Swiss National Bank (the central bank) includes a large portfolio of U.S. stocks in its investments. It recently reported a net loss of $33 billion for the first quarter of 2022, caused by its $37 billion in investment losses. In the U.S. case, the Federal Reserve in the Covid financial crisis, in cooperation with the Treasury, devised ways to buy corporate debt and even the debt of the nearly insolvent state of Illinois as investments for the central bank.
Further back in history, in the 1960s, some members of the U.S. Congress thought, with the encouragement of the savings & loan industry, that the Federal Reserve ought to buy bonds to provide money to housing. Federal Reserve Chairman William McChesney Martin resisted, arguing that this would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”
That was the right answer, consistent with Economics in One Lesson. But it did not please the politicians. Senator William Proxmire pointedly threatened the Fed:
“You recognize, I take it” he said to the Fed Vice Chairman in 1968, “that the Federal Reserve Board is a creature of the Congress? [That] the Congress can create it, abolish it, and so forth?... What would Congress have to do to indicate that it wishes…greater support to the housing market?”
A new Federal Reserve Chairman, Arthur Burns, arrived in 1971, and decided it would be a good idea to “demonstrate a cooperative attitude.” So, the Federal Reserve began to buy the bonds (not mortgages) of federal housing and other government agencies. It ended up buying the bonds of Fannie Mae, the Federal Home Loan Banks, the Federal Farm Credit Banks, the Federal Land Banks, the Federal Intermediate Credit Banks, the Banks of Cooperatives, and – believe it or not – the debt of the Washington DC subway system. There were suggestions it ought to buy the debt of New York City, when it nearly went bankrupt in 1975.
The Federal Reserve fortunately managed to get out of this program starting in 1978, but the liquidation of the portfolio lasted until the 1990s. Will it be able to get out of its vastly bigger mortgage program now?
In 1978, Hazlitt wrote in The Inflation Crisis, And How to Resolve It: “Inflation, not only in the United States but throughout the world, has… not only continued, but spread and accelerated. The problems it presents, in a score of aspects, have become increasingly grave and urgent.”
In 2022, with U.S. inflation is running at over 8%, here we are again.
As the Federal Reserve now moves to address the inflation, interest rates on the standard American 30-year fixed rate mortgage have gone from their suppressed level of 3% in 2021 to about 5½% in May 2022. Although historically speaking, that is still rather low, it will make many houses unaffordable for those who need a mortgage loan to buy. The interest expense for the same-sized mortgage for the same-priced house has increased by about 80%. How much higher might mortgage interest rates go? With higher mortgage rates, how quickly will the runaway house price inflation end? Will that be followed by a fall in U.S. house prices from their current bubble heights? We are waiting to see.