The payroll tax cut bill that will soon become law takes a small step in the right direction on policy toward the Government-Sponsored Enterprises, Fannie Mae and Freddie Mac. Congratulations to Congress for this small step; they still have a long way to go.

What the bill does

When Fannie Mae and Freddie Mac guarantee and securitize a bundle of mortgages they charge a guarantee fee or G fee for the service. The bill mandates an increase of 10 basis points (one-tenth of one percentage point) in this guarantee fee.

Since this is a fee charged by Fannie and Freddie to their clients, by itself this provision would increase revenue for the firms. The bill also requires Fannie and Freddie to passthrough that increased revenue to the U.S. Treasury. This would increase federal government revenues and reduce the budget deficit. That’s why the provision is in this bill, because Democrats are insisting that the deficit effects of preventing a tax increase be offset with provisions that reduce the deficit.

These additional 10 basis points of guarantee fee, passed through to the U.S. Treasury, would result in about $3.5 B extra revenue and deficit reduction per year for the federal government over the next decade.

My long run policy goal

I believe the Government Sponsored Enterprises should be replaced with a private market for mortgage securitization.

While in theory one could privatize Fannie and Freddie and sever all their ties to the federal government, as was done with Sallie Mae (student loans) in the late 90s, I fear, because of both the history of housing GSEs and the temptations such an effort would present to policymakers, that the result would be a continuation of the failed hybrid government-private model that has caused so many problems. Even as fully private firms, financial regulators would deem them to be too big to fail and implicitly guarantee them.  I am therefore not for reforming the GSEs, but replacing them with a private market.

Increasing the guarantee fee is a step in the right direction

Long before 2008 the government bestowed many policy and legal advantages to Fannie and Freddie, creating an implicit government guarantee for the firms. As a result lenders were willing to loan funds to these firms at a lower interest rate than to their private sector counterparts.

The 2008 crisis turned that implicit guarantee explicit.  Fannie and Freddie continue to operate with a borrowing advantage. This is a principal cause of their continued overwhelming dominance of the mortgage securitization market.

Increasing the guarantee fee reduces that borrowing advantage and weakens this government-created oligopoly. A 10 bps increase is a small step in the right direction, no matter what is done with the increased revenues.

What should be done with the increased fees?

Some investors are telling Congress that the higher fees should be left in control of Fannie and Freddie’s management rather than passed through to pay down the deficit. These increased guarantee fees should not, they argue, be “used to pay for a payroll tax cut,” and they argue that doing so undermines the prospect of future GSE reform.

The “pay for a payroll tax cut” argument is a red herring being used with Republicans who don’t like the payroll tax cut policy. Imagine if instead this were a standalone bill consisting only of the higher guarantee fee. Should those funds be used by the government for deficit reduction or left with Fannie and Freddie executives, to be used at their discretion for some other purpose?

What is a higher use of these increased revenues than to reduce the federal budget deficit?

  • Is further subsidizing other mortgages, maybe under one of the Administration’s multiple failed housing initiatives, better than reducing the deficit?
  • Is paying back private investors who own GSE debt, were bailed out by tens of billions of dollars of taxpayer funds, and are now lobbying Congress, better than reducing the deficit?
  • Is allowing Fannie and Freddie executives, the top six of whom were paid $35.4 M in 2009 and 2010 (about half to the two CEOs), flexibility to pay themselves more better than reducing the deficit?

I think these funds should be used to reduce the deficit. Packaging this deficit reduction with deficit-increasing policies that I don’t prefer (like the payroll tax cut) does not change this judgment.

Some of these investors now lobbying Congress to leave the higher revenues with the GSEs are holders of GSE debt who have apparently forgotten that taxpayers spent tens of billions of dollars to bail them out.

Does increasing the guarantee fee now undercut future replacement or reform of the GSEs?

I have heard an argument that raising the guarantee fee now will undermine future efforts to replace or reform of the GSEs. By “using” this deficit reduction to pay for something else now, the higher government revenues will not be available in future legislation, making that legislation harder to enact.

This argument is qualitatively correct but quantitatively insignificant. The GSEs’ borrowing advantage is far more than 10 basis points, so there is a lot more revenue that could be raised even to get to a level playing field. Don’t forget that these fees are only one side of the ledger. Since 2008 Fannie and Freddie have had an unlimited tap on taxpayer funds to continue functioning. These past and present subsidies exceed the proposed increase in guarantee fees. Replacing the GSEs with a fully private market, or even simply eliminating their explicit and implicit taxpayer subsidies, would still be a big deficit reducer and would therefore make future legislation quite attractive from a deficit hawk viewpoint.

The higher mandated guarantee fee and the required passthrough to reduce the deficit are good policies and small steps in the right direction.

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Addendum:  I see that Peter Wallison has a different view on whether the higher fees undercut future efforts at reform. I’d like to make three points in response.

  1. Most importantly, I would never group Peter with the self-interested investors I describe above. While many of those arguing against raising the guarantee fee and passing the revenue through to Treasury are, I think, investors and expanded government housing advocates masquerading as free market conservatives, Peter most definitely is not.  He has a longstanding record as a proponent for the strongest of GSE reforms.
  2. As described above, I’m not worried about the “piggy bank” point, because the dollar figures are small and there are outlays on the other side. Even if it is a slight deterrent, I’m willing to accept that for the benefits of reducing slightly the funding advantage the GSEs have.
  3. Peter describes other hurdles to a fully private mortgage securitization market.  I need to study these further. Assuming Peter has them right, I don’t see them conflicting with my view that raising the guarantee fee is a good thing. It means instead that raising the g fee is necessary but may not be sufficient to getting to a completely private market.