Fannie Mae and Freddie Mac need to be labeled as systemically important

Published by The Hill.

The Senate Banking Committee held a hearing this summer on whether Fannie Mae and Freddie Mac should be designated as systemically important financial institutions (SIFIs). Absolutely nobody there, no witness and no senator, tried to argue that Fannie Mae and Freddie Mac 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 $5.5 trillion. Fannie Mae is bigger than JPMorgan Chase and Bank of America, and 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,” to use the words of the Dodd Frank Act. 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 in 2007-2009. The activity of Fannie and Freddie is entirely about leveraging real estate. Moreover, they have been historically, and are today, themselves hyper leveraged.

The Financial Stability Board has stated this fundamental description of a SIFI: “the threatened failure of a SIFI — given its size, interconnectedness, complexity, cross-border activity or lack of substitutability — puts pressure on public authorities to bail it out using public funds.” Fannie and Freddie displayed in their 2008 failure and continue to display the attributes of extremely large size, interconnectedness, complexity, cross-border activity, and lack of substitutability. As everybody knows, in 2008, federal authorities not only felt overwhelming pressure to bail them out, but did in fact bail them out. In addition, they pledged the credit support from the Treasury which protected and continues to protect Fannie and Freddie’s global creditors. Fannie and Freddie remain utterly dependent on Treasury’s credit support.

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 GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee.” Paulson instructed the Treasury staff to “make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.” He memorably added, “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, Paulson’s assurances turned out to be true for all of Fannie and Freddie’s creditors, even holders of subordinated debt. In short, that Fannie and Freddie are SIFIs in reality no reasonable person can dispute. 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 and Freddie have an existing regulator, the Federal Housing Finance Agency (FHFA). But the FHFA is not, nor is it empowered to be, a regulator of the systemic risk created by Fannie and Freddie for the banking and financial system as a whole.

Fannie and Freddie 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 also the Office of Thrift Supervision, abolished in 2010. It is easy to picture a future FHFA, under the appointments of a future administration, behaving similarly in that perpetual fount of systemic risk, leveraged real estate.

Designating Fannie and Freddie as SIFIs should not be delayed because they are in regulatory conservatorship. They are just as systemically important in conservatorship as out of it. The answer to the Senate Banking Committee’s excellent question is that it is high time to recognize reality and designate Fannie and Freddie as the SIFIs they so obviously are.