Limiting Fannie Mae's and Freddie Mac's Portfolio Size

CRS Report for Congress
Limiting Fannie Mae’s and Freddie Mac’s
Portfolio Size
N. Eric Weiss
Analyst in Financial Institutions
Government and Finance Division
Summary
One of the more controversial aspects of the Government Sponsored Enterprise
(GSE) reform before Congress is the proposal to limit the size of Fannie Mae’s and
Freddie Mac’s portfolio to reduce the risk to the federal government and the economy.
In 2003, these GSEs’ combined investment portfolio had risen to $1.6 trillion from $136
billion in 1990. These investment portfolios include mortgages and mortgage-backed
securities (MBSs) that are subject to several types of financial risk. If these risks are not
managed properly, or if market movements turn dramatically against the GSEs, the
government may face two unsatisfactory alternatives: either let the GSE go into default
and hope that the financial repercussions can be controlled, or step in and assume
payments on the GSE debt at a significant cost to taxpayers. Proponents of portfolio
limits argue that shrinking portfolio size reduces the likelihood and cost if this choice
ever has to be made. The GSEs and their supporters argue, on the other hand, that the
profits generated by the investment portfolios enhance the GSEs’ ability to support
affordable housing programs and reduce mortgage interest rates.
S. 190 and H.R. 1461 propose many changes in the rules governing the activities
and regulation of Fannie Mae and Freddie Mac. S. 190 as ordered reported to the full
Senate includes portfolio limits. H.R. 1461 does not.
Fannie Mae signed a consent agreement on May 23, 2006, with the Office of
Federal Housing Enterprise Oversight (OFHEO) agreeing to cap its retained mortgage
related portfolio to its level on December 31, 2005 ($727 billion). OFHEO’s Acting
Director James B. Lockhart III is seeking a similar cap from Freddie Mac. In June 2006,
the U.S. Treasury and Department of Housing and Urban Development (HUD)
announced separate inquiries that could lead to restrictions on Fannie Mae’s and Freddie
Mac’s ability to finance their mortgage-related portfolios.
This report analyzes the advantages and disadvantages of proposals to limit
portfolio size. It will be updated as warranted by significant developments.

Congressional Research Service ˜ The Library of Congress

Federal Reserve Chairman Ben S. Bernanke,¹ former Federal Reserve Chairman
Alan Greenspan,² and former Treasury Secretary John Snow³ have warned that the
mortgage portfolios of Fannie Mae and Freddie Mac present a risk to the nation’s
financial system and federal government.
Figure 1. Combined MBSs Outstanding and
Retained in GSE Portfolios

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Fannie Mae and Freddie Mac buy mortgages from the original lenders and package
them into mortgage-backed securities (MBSs), which are either sold to investors or held
in portfolio by the GSEs themselves.⁴ These portfolios are large and have grown rapidly,
both in dollar terms and as a percentage of all MBSs outstanding. According to the most
current complete information (the end of 2003),⁵ Fannie Mae’s retained mortgage⁶⁷
portfolio was $902 billion and Freddie Mac’s was $661 billion. At the end of 2003,
their combined portfolios were more than 11 times their size in 1990. Under S. 190, the
¹ Written response from Ben S. Bernanke, Chairman of the Federal Reserve, to the Senate
Committee on Banking, Housing and Urban Affiairs, Nov. 15, 2005, available at
[http://online.wsj .com/ public/resour ces/documents/bernankebunning11212005.pdf].
² Letter from Alan Greenspan, then Chairman of the Federal Reserve, to the Honorable Robert
F. Bennett, U.S. Senate, Sept. 2, 2005, at [http://online.wsj.com/public/resources/documents/
Greenspan091505.pdf].
³ U.S. Department of Treasury, “Testimony of Secretary John W. Snow Before the U.S. Senate
Committee on Banking, Housing and Urban Affairs. Proposals for Housing GSE Reform,” press
release, Apr. 7, 2005, at [http://www.treas.gov/press/releases/js2362.htm].
⁴ A relatively small number of mortgages are directly held in the GSEs’ portfolios.
⁵ Because of accounting problems, Fannie Mae’s 2004 financial reports are not available.
⁶ U.S. Office of Federal Housing Enterprise Oversight, 2005 Report to Congress, Table 4, p. 31.
⁷ Ibid., Table 14, p. 47.

GSEs could purchase mortgages and MBSs only for the purpose of securitization and sale
to others. (Existing portfolios are grandfathered out of this provision.) Figure 1, above,
illustrates the growing size of the combined portfolios and the amount of MBSs
outstanding.
Why Are the Portfolios So Large?
The GSEs are designed by their congressional charters to be profit-motivated
enterprises. Their portfolios have grown as part of profit maximization. The GSEs have
a funding advantage that appears to be unlimited because of the close connection between
the GSEs and the federal government. Market forces that limit the size and risk of other
financial intermediaries’ portfolios do not apply to the GSEs. The GSEs can borrow more
money at lower rates. These rates are slightly higher than the comparable Treasuries, but
lower than companies (or competitors) with similar financials that lack a federal
government connection. Federal Deposit Insurance Corporation staff has estimated that
without the implicit guarantee, the GSEs would have credit ratings of AA or A, rather
than their current AAA ratings. This reduced cost of borrowing can give the GSEs a
profit advantage in any activity they undertake. Relatively little money is required to
finance the purchase of mortgages while they are being combined into MBSs. When
MBSs are sold, money borrowed can be repaid. Because short-term bonds and loans have
lower interest rates than long-term ones, the GSEs use portfolio management techniques
to allow them to borrow using short-term bonds to finance long-term mortgages. The key
issue is whether the benefits of this portfolio growth to the companies and homeowners
exceed their costs to the nation. The main cost is the implied guarantee of GSE debt
provided by the federal government without charge. The more GSE debt, the greater the
value of the implicit guarantee, the larger the portfolios, and the greater the profit.
There are some benefits to the nation from the GSEs’ portfolio. Section 128 of H.R.
1461 would require the GSEs to contribute 5% (3.5% in the first year) of their profits to
an affordable housing fund. The higher the profits are, the larger this fund will be. Based
on recently available results, CRS has estimated that this contribution will be $380⁸
million in the first year and $540 million in later years.
The GSEs say that large portfolios add liquidity to the secondary mortgage market.
Independent analysts do not dispute that a retained portfolio and active trading can help
to maintain a liquid market for MBSs and encourage investments in them. (The reason
that the portfolios contribute to liquidity is that they allow the GSEs to sell and buy MBS
when others are unwilling.) They disagree that the portfolios need to be as large as they
are.
The exact distribution of the benefits of the GSEs’ status is subject to debate. CBO
has concluded that the GSEs retain more than 40% of the subsidy from the implicit
guarantee.⁹ The larger their portfolios, the more implicitly guaranteed borrowing, and the
larger the GSEs’ profits. In contrast, the benefit to homeowners is largely independent

⁸ CRS Report RS21724, GSE Regulatory Reform: Frequently Asked Questions, by Loretta Nott
and Barbara Miles.
⁹ U.S. Congressional Budget Office, Assessing the Public Costs and Benefits of Fannie Mae and
Freddie Mac, May 1996. Available at [http://www.cbo.gov/ftpdocs/0xx/doc13/Fanfred.pdf].

of portfolio size and is estimated to result in mortgage rates that are lower by 7 to 40 basis
points (0.07% to 0.40%).¹⁰ On the maximum single-family loan that Fannie and Freddie
may purchase ($417,000) at a rate around 6.5% rate, this saves the homeowner $0.05 to
$0.30 per day, or $20 to $110 per year.
GSE Risks
The GSEs share many risks with all business. These risks can affect the companies,
stockholders, employees, bondholders, and business partners. The GSEs’ risks can also
affect the nation’s financial system and the economy. There are many ways to analyze
these risks. One useful strategy is to look at credit risk, prepayment risk, interest rate risk,
and operational risk.
Credit Risk. Credit risk is the risk that the borrowers (mortgagors) will not repay
their loan on time — in other words, the risk of delinquency and default. When Fannie
and Freddie buy mortgages and combine them into MBSs, they add their guarantee that
the loans will be repaid on time. They charge an annual fee of about 20 basis points
(0.20%) for this guarantee. Standard & Poor’s and most other major observers conclude
that because of the different maturity dates, loan-to-value ratios, private mortgage¹¹
insurance, and geographic diversification, credit risk is not a serious problem.
Prepayment Risk. Prepayment risk is potentially more serious. This is the risk
to an investor that a 30-year mortgage will be paid before the full 30 years is concluded.
Homeowners prepay for two major reasons: moving, and to obtain more favorable terms.
As the cost of refinancing has declined over the last 10 years, the decline in interest rates
necessary to justify refinancing (with or without cash out or financing improvements to
the home) has been reduced. In recent years, the decline in mortgage rates has caused
prepayment rates to increase. This results in uncertainty for lenders and the holders of
MBSs.¹² When the GSEs create MBSs and sell them to investors, this is a risk for the
investor, not the GSE. When GSEs keep the MBSs, this is a risk to them.
Interest Rate Risk. Interest rate risk comes from financing the MBS portfolios
by borrowing money (issuing bonds), and is related to prepayment risk. In 2003, Fannie
had $962 billion of debt outstanding; Freddie had $740 billion. Fannie and Freddie use
short-term bonds and financial derivatives to finance long-term loans. University of
California at Berkeley finance professor Dwight Jaffee has demonstrated how either an
increase or decrease in market rates can cause the GSEs’ unhedged portfolios to lose
value.¹³ When interest rates increase, they must roll over their bonds with higher-rate

¹⁰ CRS Report RL32795, Government-Sponsored Enterprises (GSEs): Regulatory Reform
Legislation, by Mark Jickling.
¹¹ James R. Haggerty, “Mortgage-Securities Drop Will Depend on Economy,” The Wall Street
Journal, Sept. 17, 2005, p. B7.
¹² Since 1986, the GSEs have offered multiclass MBSs, which divide prepayment risk among the
different classes. They are customized for investors to match their tolerance and preference for
prepayment risk versus anticipated yield.
¹³ Dwight Jaffee, “On Limiting the Retained Mortgage Portfolios of Fannie Mae and Freddie
(continued...)

ones. When interest rates decrease, homeowners prepay their mortgages, and the GSEs
buy new ones at lower rates. To minimize the losses that occur when interest rates
change, the GSEs constantly use sophisticated portfolio management techniques,
including derivative securities. One technique they have used involves selling callable
bonds that give them the option to pay the bonds off before the stated maturity, much as
mortgagors prepay mortgages.
Interest rate risk can be very serious. Many savings and loan associations became
insolvent in the early 1980s because of it. During that time, Fannie Mae’s portfolio was
poorly hedged. According to Secretary Snow, “Fannie Mae became insolvent on a mark-
to-market basis. Only a combination of legislative tax relief, regulatory forbearance, and
a decline in interest rates allowed Fannie Mae to grow out of its problem.”¹⁴ Despite
state-of-the-art hedging today, the GSEs’ portfolios have significant interest rate risk.
Former Chairman Greenspan wrote: “Moreover, the success of interest-rate-risk
management, especially the exceptionally rapid timing necessitated by dynamic risk
adjustments, requires that the ultimate counterparties to the GSEs’ transactions provide
sufficient liquidity to finance an interest-rate-risk transfer that counters the risk.
Otherwise, large and destabilizing adjustments will result in sharp changes in the interest
rates required to rebalance and hedge a portfolio.”¹⁵ In other words, if the GSEs have to
make large adjustments to their portfolios, only very large financial institutions will be
able to handle the other side of the financial transactions.
Operational Risk. Operational risk is the risk of loss due to inadequate or failed
internal procedures and systems. It is addressed by the various reforms in the House and
Senate bills that increase regulatory powers, and in S. 190 reducing the size of the GSEs’
portfolios. A smaller portfolio would be easier to adjust because the size of transactions
would be smaller. It would be possible to find more counterparties for these smaller
transactions. In addition, the risk to the financial system from possible future accounting
and other operational problems would be less with smaller enterprises. Limitations on
portfolio size are consistent with other changes in the proposed legislation.
Fannie Mae’s current accounting problems, and those of Freddie Mac in 2003, raise
questions about internal controls. Accounting systems provide the basis for portfolio
adjustment decisions. If the accounting system is providing inaccurate information, the
resulting portfolio adjustment decisions are likely to be incorrect.

¹³ (...continued)
Mac,” 2005, available at [http://repositories.cdlib.org/iber/fcreue/fcwp/294/].
¹⁴ U.S. Department of Treasury, “Testimony of Secretary John W. Snow Before the U.S. Senate
Committee on Banking, Housing and Urban Affairs. Proposals for Housing GSE Reform,” press
release, April 7, 2005, p. 4, at [http://www.treas.gov/press/releases/js2362.htm]. See also, the
Miscellaneous Revenue Act of 1982 (P.L. 97-372, 96 Stat.1726 et seq.), especially Section 102,
titled “Adjustment to Net Operating Loss Carryback and Carryforward Rules for Federal National
Mortgage Association.”
¹⁵ Letter from Alan Greenspan, then Chairman of the Federal Reserve, to the Honorable Robert
F. Bennett, U.S. Senate, Sept. 2, 2005, p. 1, at [http://online.wsj.com/public/resources/documents/
Greenspan091505.pdf].

Former Chairman Greenspan raised the concern that as the GSEs’ portfolios have
grown, the size and number of transactions needed to rebalance their portfolios have
increased. As the size of the adjustments required has increased, the number of financial
institutions that can meaningfully participate has decreased.
Reducing Systemic Risk
At a summary level, risk has two dimensions: the probability that the event will
occur and the cost if it does. A complete approach to reducing risk works on both aspects.
Reducing the size of the portfolios would reduce both dimensions.
The implied guarantee allows the GSEs to grow without the usual market forces that
would raise their costs as their risks rose. As a result, Fannie and Freddie represent
significant systemic risk to the nation’s financial system, both because they can make
mistakes and because their size and concentration raise the likelihood of high costs for the
economy when they do. With smaller portfolios, the GSEs would be able to adjust more
nimbly to changing financial markets.
Reducing the seriousness of the systemic risk requires reducing the size of the
implied guarantee. Some have proposed complete privatization of the GSEs, such as
occurred for the college student loan market when Sallie Mae gave up its congressional
charter and became entirely private. This would totally eliminate the implied guarantee.
The GSEs would be subject to market forces that might drive them to reduce the size of
their portfolios. This option is not currently before Congress. Closer regulation along the
lines proposed in H.R. 1461 and S. 190 would reduce much of the operational risk, but
risks coming directly from the size of the portfolios of mortgages and retained MBSs
would remain as long as the portfolios remain larger than necessary to provide a liquid
secondary mortgage market.
While it is true that this would distribute the risk more widely, this is less of a
concern because the cost of a bailout would be less for any one company. In addition, it
is likely that these other companies would use simpler ways to fund their portfolios,
which would reduce the risk of hedging errors.