The Federal Reserve created a new round of controversy for Fannie Mae and Freddie Mac—and for itself—when its staff economist Wayne Passmore released a new study on the Government-Sponsored Enterprises (GSEs) in December 2003. The study attempted to measure the subsidy value Fannie and Freddie enjoy being government sponsored. But it quickly drew a firestorm of criticism for what housing and investment analysts saw as a variety of flawed assumptions.

According to Passmore, the actions of the GSEs only reduce mortgage rates by about seven basis points, and “The GSEs' implicit subsidy does not appear to have substantially increased homeownership or home building because the estimated effect of the GSEs on mortgage rates is small.” While Passmore estimates the subsidy's worth to be between $119 billion and $164 billion, a substantial portion of the value—between $50 and $97 billion by Passmore's estimate—accrues directly to the benefit of GSE shareholders, he calculated.

Passmore's study prompted quick rebuttals from the NAHB, Fannie Mae, and others. The primary flaw in the study, according to David Berson, Fannie Mae's chief economist and a former classmate of Passmore, was in the loan data used in the calculations. The study relied on loan information that doesn't normally reflect the rate differential between jumbo and conforming mortgages commonly observed in the marketplace. Using a more realistic 25-to-30 basis point differential in the net subsidy equation “wipes out the retained subsidy completely,” according to Fannie Mae.

Greenspan Grievances The debate heated up considerably when Federal Reserve Chairman Alan Greenspan testified before the Senate Committee on Banking, Housing, and Urban Affairs in late February. In addition to highlighting Passmore's finding that the implicit subsidy may account for more than half of the equity market value of Fannie and Freddie, Greenspan expressed concern with the size of the GSEs' mortgage portfolios and resulting concentration of interest rate and prepayment risk. “There are many ways to enhance the attractiveness of homeownership at significantly less potential cost to taxpayers” than under the current arrangement, said Greenspan.

In his testimony, Fannie Mae CEO Franklin Raines argued that the ability of the GSEs to attract low-cost funding is not predicated solely on the existence of a government “subsidy.” Raines highlighted a study on Fannie Mae's management of liquidity risk by Columbia University professor Glenn Hubbard, former chairman of the Council of Economic Advisors. Hubbard's research indicated that the operating results of Fannie Mae had been less volatile than those of large commercial banks and thus the overall business risk may be lower as well. According to Hubbard, “This possibility and its implications for differences in funding costs between Fannie Mae and other financial institutions have not been fully explored in recent studies.”

Future Of GSEs Wall Street's reaction to Greenspan's testimony was also pointed. In a Feb. 25 report, Morgan Stanley Mortgage Finance analyst Ken Posner wrote, “Theoretical arguments based on imprecise econometric analysis don't help Congress address [our nation's] housing goals … . Why not do away with the mortgage tax deduction?” which Posner described as an extremely regressive subsidy. Michael Cohen, specialty finance analyst at CIBC World Markets, disagreed with Greenspan's views about the contribution of the GSEs to homeownership. “We believe [the spike in loan volume at the conforming limit] is clear market evidence that borrowers see the benefit of conforming loans,” says Cohen.

Any analysis of the true benefit of the GSEs as a mortgage buyer in which liquidity isn't taken into account or is “the major consideration is erroneous in my opinion,” added Ryan Caldwell, investment analyst at Overland Park, Kan.-based Waddell & Reed Investment Management.

According to Raines, the benefit of that liquidity is clear in helping to make “long-term, fixed-rate mortgage more affordable and more available to families.”