[Economic Report of the President (2006)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
Chapter 9

The U.S. Financial Services Sector

Everyday life tends to expose people to the financial services
sector. For example, people make deposits at banks and obtain loans
from them. Nevertheless, understanding what this sector does can be
difficult. Why do individuals go to intermediaries like banks for
mortgages, rather than skip intermediaries (and their costs) and
deal directly with savers? And why do financial service firms ask
for so much information before making a loan and, afterward, place
so many restrictions on borrowers?
This chapter explores what financial services do for an economy, how
financial development relates to economic performance, and how
financial services can be effectively regulated. In particular, it
develops the following conclusions.
 The financial services sector addresses informational
problems that can otherwise keep financial capital from
finding productive uses. Moreover, the U.S. financial
services sector tends to deliver these services in a  cost-effective manner.
Financial services facilitate innovation and thus encourage
the economic growth that is necessary to increase living  standards over time.
They might also bolster economic  stability.
Financial regulation should protect consumers and ensure the
system's safety and soundness. Moving too far in the public   regulation
direction, however, can stifle the productivity and innovation that are necessary
for the economy to enjoy   fully the benefits of financial services. An effective
financial regulatory system appropriately balances the costs
and benefits of public regulation.
The Economic Roles of Financial Services
Financial services address information problems inherent in lending
and investing. This section explains this and other benefits, and
presents evidence that the United States enjoys a comparative
advantage in producing financial services.
Financial Services Address Information Problems in Lending and
Investing
Adverse Selection In general, information problems can hinder efficient economic
behavior. Consider an example from the used-car market. In this
market, sellers are likely to have better information than do buyers
about the cars being sold. A buyer might have general information
about the quality of a certain model, but the seller likely enjoys
additional information about the particular car that is being
considered. In this and related cases, information is said to be
distributed asymmetrically across the transaction's parties.
Economic theorists have shown that, absent a tool for reducing
information asymmetries, only the worst-quality cars will be sold.
In the case of the used-car market, given the general nature of the
buyer's information, he or she may be willing to pay only the average
price that the model under consideration tends to command. But
sellers may then only offer cars that are below average in
quality--i.e., "lemons." Indeed, a seller would incur a loss by
selling an above-average car at a price based on the value of the
average car. Consequently, high-quality cars might never make their
way to the market.
This tendency for sellers of lemons to adversely select themselves
creates difficulties in a number of markets, including those for
financial capital. For example, just as a used car's owner has
relatively good information about that car's quality, a manager
likely has better information about his or her business projects
than does an outside supplier of financial capital. This information
asymmetry, in turn, can encourage "low-quality" projects to adversely
select themselves into the financial market. As in the automobile
example, relatively well-informed sellers (managers) may want to
withhold highly valued assets (the right to share in the proceeds of
a new project) if the general nature of available information lets
buyers bid only an average price. An economy may thus forgo the very
projects that are important for its performance.
Moral Hazard
The above discussion shows that, when information is asymmetric
before a transaction takes place, the side with relatively good
information can adversely select itself. The prospect of this
strategic behavior can discourage the financing of otherwise
valuable projects. But even if parties to a potential transaction
can address this problem, information can still be asymmetric
after a transaction takes place. This latter type of asymmetry
is known as moral hazard and, left untreated, it too can hinder
economic efficiency.
Like adverse selection, moral hazard is problematic for a number
of markets. For example, because insurance customers have better
information about their behavior than do insurers, an individual
who buys insurance can subsequently take on too much risk. Here,
an insured driver might enjoy the benefit of driving faster (e.g.,
the value of time saved) while passing at least some of the costs
on to the insurance agency (e.g., the value of an expected claim).
A similar phenomenon plays out in more narrowly defined financial
services. Indeed, just as insurance customers tend to have better
information about their behavior than do insurance sellers,
businesses and households tend to have better information about
how they use loans than do lenders.
Lending contracts, like insurance contracts, may thus be plagued by
moral hazard problems. A manager might, for example, pursue a
project that is more risky than what was agreed upon when the loan
was made. In doing so, the manager enjoys the benefit of projects
that ultimately perform well, but passes the cost of poorly
performing projects onto the firm's lenders. Absent an institution
that would discourage managers from acting in this manner, suppliers
of financial capital will be reluctant to offer financing. Again,
the problem of asymmetric information can lower an economy's level
of productive activity. Financial Services Can Mitigate Adverse Selection and
Moral Hazard The above discussions show that information problems can impede the
efficient use of financial capital. Because these problems can stand
in the way of better outcomes for both demanders (i.e., businesses,
households) and suppliers (i.e., savers) of financial capital,
opportunities exist for a third party to reduce informational
obstacles. Financial service providers frequently play this
important intermediary role.
Financial service firms can, for example, build expertise in
evaluating and monitoring borrowers. Understanding what is, and what
is not, a productive project can check the problem of adverse
selection. An effective monitoring program can then keep borrowers
on task with agreed-upon projects and thus limit moral hazard
problems.
Demanding collateral can help mitigate information problems in this
regard. To see how, suppose that a low- and a high-quality applicant
ask for a loan and notice that, while information about quality is
important for deciding whether to grant a loan, low-quality
applicants may not want to divulge that information. In terms of the
above discussion, lenders are worried about low-quality individuals
adversely selecting themselves into the pool of applicants.
Asking for collateral can address this problem by encouraging
applicants to truthfully (rather than strategically) reveal this
information. Here, high-quality applicants are more willing to post
collateral because they are more confident that they will not lose it.
In this manner, collateral requirements can induce applicants to
truthfully separate themselves into distinctive types of borrowers
(rather than strategically masquerade as more attractive types).
Likewise, asking for collateral can mitigate the problem of moral
hazard. Recall from the above discussion that borrowers may find it
attractive to opportunistically increase a project's risk. Collateral
requirements can mitigate this problem by essentially exposing the
borrower's own capital to such risk taking.
In each case, financial service firms reduce informational obstacles
that can stand in the way of lending. A good project can benefit both
the project's manager and lenders. But because managers tend to have
better information about projects, both before and after the projects
are underway, passive lenders will be reluctant to offer the requisite
funding. By specializing in setting collateral requirements and
evaluating and monitoring projects, financial service firms can play
the important economic role of reducing such asymmetries.
Financial Services Reduce the Cost of Collecting Information
A well-developed financial system not only mitigates information
asymmetries, it does so in an efficient manner. Notice from the
above example that individual savers could, in principle, mitigate
these asymmetries themselves.  In doing so, however, they would
unnecessarily reproduce the same information a number of times. The
relatively high cost of collecting information in this manner would
still leave an economy with considerable information asymmetries and
thus prevent financial capital from being matched with its most
productive uses.
A reputable car dealer illustrates this point. After carefully
examining a car, a dealer might offer a guarantee. In that case,
prospective buyers can take some confidence from the guarantee
itself, as opposed to having to reproduce information about the
same car through repeated examinations. In a competitive
environment, the associated cost savings can make their way to
consumers. By essentially delegating the process of information
discovery to experts, savers can likewise benefit from having
financial service firms examine prospective investments on their
behalf. In both cases, intermediaries not only facilitate mutually
beneficial trades by reducing information asymmetries, they produce
these benefits in a relatively low-cost manner.
Other Benefits of Financial Services
Diversifying Investment Risks
In addition to being concerned with asymmetric information problems,
individuals are concerned with the fundamental risks to which their
savings are exposed. Indeed, independent of information problems,
the return on investments can be very uncertain. This type of risk
can also discourage financial capital from finding productive uses.
Financial services can address this problem by economizing on the
costs of investing in diversified pools of loans.
By saving at a bank, for example, individuals do not expose
themselves to the risk of any one investment. Instead, they can
participate in the return from a pool of investments, some of which
will perform better at times than do others.  On average, then,
savers can reduce the volatility that they would otherwise face in
an undiversified portfolio while maintaining a relatively high rate
of return.
Transforming Long-Term Investments into Liquid Assets
Financial services can economize on the cost of providing liquid
access to even long-term investments. Individuals tend to save
because they want to expand their consumption opportunities in the
future. But while investments in assets like long-term loans might
be good at expanding these opportunities, they are typically not
good at facilitating exchanges. It is much easier to buy groceries,
for example, with currency than it is with a long-term loan. Absent
a mechanism that can readily transform loans into more readily usable
forms of money, savers will again be reluctant to invest in projects
that could otherwise be mutually beneficial.
Financial firms provide savers with liquidity. Banks, coupled with
Federal deposit insurance (discussed in the Policy section below),
can fund long-term business projects while fulfilling the transaction
demands of depositors. Absent such a service, savers may be reluctant
to commit their capital for longer periods of time. But innovative
projects frequently need long gestation periods to build themselves
into productive endeavors. By giving savers ready access to the
proceeds of even long-term investments, financial services again
encourage capital to find its best uses.
Providing Cost-Effective Means of Payment
The financial sector also furthers economic well-being by economizing
on the costs of producing payment services. The most widely used
means of payment, cash, is a good way to make small purchases, but
creates difficulties for larger transactions and those made from a
distance. Financial services have found innovative ways to make life
easier here.
Services like processing checks and conducting electronic funds
transfers, to name a couple, can enhance the speed, safety, and
convenience of transacting. In addition, means of payment like these
can open up opportunities to better match consumers with the
producers of goods and services that they demand. Finally, the
potential to expand these already considerable benefits is large.
By moving even further toward an electronic payment system, for
example, the savings in postage costs alone could reach into the
billions of dollars.
The United States Enjoys a Comparative Advantage in Financial
Services
The U.S. financial services sector has been making increasing
contributions to GDP over the past several decades. The growing
importance of this sector to the U.S. economy owes, in part, to the
U.S. global comparative advantage in the production of financial
services.
Chart 9-1 shows how financial services, such as central banking,
taking deposits, and making loans, have accounted for a growing
share of U.S. nominal GDP. This contribution has increased steadily
from about 2 percent in 1977 (the first year for which data are
available) to about 4 percent in 2003 (the most recent year for
which data are available).

The growing importance of the financial services sector is consistent
with U.S. workers having a global comparative advantage in the
production of financial services. For example, financial firms open
offices in other countries to serve foreigners (i.e., to export
their services). Since 1997 (the first year for which these data
are consistently available), exports of financial services have
outpaced imports, with exports increasing by about $15 billion and
imports increasing by only about $5 billion. In 2004, financial
service exports totaled $27 billion while imports of financial
services were only $11 billion.
Economic Growth and Stability
The above discussion highlights the potential for financial services
to mitigate information asymmetries and economize on transactions
costs. Recent research cites these attributes as important channels
through which financial services can increase living standards and
promote economic stability. This section elaborates on the general
economic benefits that financial services can generate in this
regard.
Financial Development and Economic Growth
Well-developed financial markets are important for economic growth.
Equipped with a comparative advantage in reducing information
asymmetries and transactions costs, financial service firms can
productively identify and guide promising entrepreneurs, and thus
pave the way for scarce resources to find innovative projects.
Innovations, in turn, can help turn a fixed amount of resources into
more output, and thus facilitate increases in living standards.
This funneling of resources to productive projects can also encourage
the replacement of outdated and inefficient technologies. Absent
productive financial services, for example, individuals can pursue
innovations only when they have enough resources to get their
projects off the ground. "Idea-rich" but "capital-poor" innovators
pose little threat to a market's incumbents, who can become
complacent and set the stage for poor performance to entrench itself.
By easing the way for newcomers to participate in the economy,
financial services can hasten the replacement of bad ideas with
growing opportunities. Box 9-1 discusses the role of financial
intermediaries in the development and implementation of particularly
innovative ideas.
---------------------------------------------------------------------
Box 9-1: Venture Capital and Innovation
Venture capitalists raise funds, search for profitable investments,
and then guide investments until sufficient proceeds can be returned
to the original contributors. Working through this process, venture
capitalists can be especially successful in identifying and guiding
productive innovations. An influential study finds, for example,
that a dollar of venture capital produces about three times more
patents than does a dollar of corporate research and development
(R&D). In addition, patents that ultimately emerge from venture
capitalization tend to be of high quality.
The previous section of this chapter showed that asymmetric
information can slow, or even preclude, mutually beneficial
transactions from taking place. In this way, information problems
can prevent financial capital from flowing to its most-productive
enterprise. These problems can become even more difficult when the
project that seeks funding is an innovative one. Indeed, the features
of innovative projects tend to be intangible, and thus expand
opportunities to strategically act on informational advantages.
Without a mechanism for dealing with these advantages, an economy
may thus forgo projects that would contribute most to its growth.
Venture capital firms are one such mechanism. Their expertise in
identifying productive ideas and creating incentive structures that
productively guide development therein lets them attract the type of
long-term steady funding that is necessary to see innovations
through from start to finish. This necessity for commitment creates
risks that do not let other intermediaries succeed. Here, for
example, even the most innovative borrowers may lack the credit or
business track record that would make them attractive prospects to
conventional lenders. Venture capitalists overcome such obstacles by
taking extraordinary measures to examine prospective projects and
maintaining a hands-on approach after making an investment. One
study indicates that by discovering worthy projects and shepherding
them to fruition, venture capitalists are able to annually attract
upward of $100 billion in funding, and channel this capital in a
manner that accounts for about 14 percent of U.S. innovative
activity.
--------------------------------------------------------------------
Consistent with the argument that financial services encourage growth
and discourage entrenchment, one study finds that industries that
tend to lack their own funding (and thus rely heavily on external
sources to finance projects) grow significantly faster when they are
located in countries that have well-developed financial
intermediaries (such as banks). In addition, studies show that
countries that maintain well-developed financial systems tend to
grow their economies at relatively high rates.
This relationship between financial development and economic
performance also shows up in data from U.S. states. The relaxation
of multi-state branch banking restrictions since the mid-1970s, for
example, appears to have improved the quality of U.S. bank lending
(as measured by a decline in nonperforming loans). Evidence suggests
that the entrepreneurial sector responded to this enhanced
development by leading state-level economies onto higher and more
stable growth paths. Looking at data at the firm- and economy-levels,
as well as across countries and U.S. states, researchers have thus
found evidence to suggest that an economy's living standards and
growth prospects depend to a considerable degree on its financial
development.
Financial Services and Economic Stability
The above discussion suggests that economic growth increases with the
development of financial markets and services. Fortunately, such
long-term benefits need not compromise short-term stability. Indeed,
financial development may contribute to a reduction in the volatility
of economic activity.
The reduction in economic volatility over the past several decades is
well documented. As indicated in Chart 9-2, the volatilities of real
output and consumption growth (measured by their standard deviations
over 20-quarter periods) have both trended down since 1950. This
remarkable decline in aggregate volatility, coined "The Great
Moderation," appears to have set the stage for a stable macroeconomic
landscape that better avoids the inefficiencies that might emerge
from increased economic uncertainty.
The evolution of the financial system may have played an important,
though not exclusive, role in the Great Moderation. One change in the
financial system that may have contributed to the Great Moderation
was the removal of regulations that created volatility. Evidence
suggests, for example, that Regulation Q, which limited the maximum
interest that banks could pay on deposits until its repeal in 1980,
depressed lending in high-interest-rate environments. As a result,
banks may have created volatility by translating financial shocks
into real ones.
The Great Moderation may also reflect the financial system's
development of more sophisticated ways of managing and sharing risk.
For example, banks now use derivative securities to insulate their
balance sheets from interest-rate risk. Derivatives are contractual
arrangements that specify payments between parties, where the
payments are usually tied to some observable and verifiable measure
(e.g., an interest rate or stock market index). Banks may also use
derivatives to essentially purchase insurance against the defaults
of large loans. In addition, banks have developed new methods for
selling loans to investors through securitizations, the process of
pooling loans and selling claims on these pools to dispersed investors

Further, innovations in consumer financial products offered by banks,
such as cash-out-mortgage refinancing (COMR), may have helped to
moderate economic fluctuations. This role was evident in 2001, the
year of the most recent recession, when households reportedly
extracted $83 billion of home equity, up from $26 billion in the
prior year. In addition, the widespread distribution of consumer
credit has almost certainly allowed many individuals to insulate
themselves from short-term economic shocks.
Policy Issues
The financial services sector appears to favorably affect economic
growth and may also reduce economic volatility. As the above
discussions about financial mechanisms such as collateral and
monitoring illustrate, private financiers do a lot to facilitate
financial development. However, public policy plays a productive
role. In particular, the desire to protect consumers and ensure
the safety and soundness of the financial system has motivated
policies in this area.
Consumer Protection
Policies protect consumers in a number of settings. The Food and Drug
Administration (FDA), for example, requires producers to disclose
certain nutritional content and other information about their
products. In the financial services sector, the Truth-in-Lending Act
also requires informational disclosures. The Act requires that
consumers be made aware of information about the amount and rate of
interest that they are paying on a loan.
A consumer-protection issue of current interest is identity theft.
To conduct their operations and reduce the risks of lending,
financial service firms rely heavily on the Nation's credit-reporting
system to both assess risk and verify the identity of credit
applicants. Identity thieves prey on this system by using another
consumer's personal information to obtain credit in the consumer's
name.
Identity theft is a considerable problem. In 2005, banks, credit card
companies, retailers, and data brokers were involved in high-profile
security breaches that affected up to 50 million account holders. The
entity whose security is breached generally bears the costs of direct
losses from identity theft. However, consumers bear significant
indirect costs of verifying fraudulent charges and correcting the
damage to their credit profiles.
The Administration has taken substantial steps to protect individuals
from identity theft. In 2003, the President signed the Fair and
Accurate Credit Transactions Act, which allows all Americans free
access to review credit reports annually to ensure the security and
accuracy of their credit reports and to protect against identity
theft. In 2004, the President signed the Identity Penalty Enhancement
Act, which defined a new crime of "aggravated identity theft" and
increased penalties for identity fraud. Congress may enact additional
protective measures, and the Administration has recommended that it
consider extending to brokers and other entities the consumer
safeguards that govern the way financial institutions secure their
databases. The Administration also supports narrowly tailored
legislation requiring companies to notify consumers if the security
of their information has been breached in a manner that creates a
significant risk of identity theft. Enacting this legislation would
result in uniform national rules for dealing with identity theft,
rather than the current patchwork of inconsistent state and local
regulations. Of course, some regulations can be overly burdensome if
not carefully crafted (see Box 9-2 for additional discussion).
---------------------------------------------------------------------
Box 9-2: Regulation Is Not Costless
While regulation can improve economic performance, it can also have
the opposite effect if not carefully crafted. For instance, if
consumer-protection laws for some transactions are unduly burdensome,
financial service firms may stop engaging in those transactions
altogether. Therefore, regulations must carefully assess the overall
benefit to consumers to be sure the regulation's benefits outweigh
its costs.
Excessive regulation can increase the cost of producing financial
services. The now-repealed Glass-Steagall Act is illustrative. The
Act prohibited banks from producing commercial and investment
services under the same roof. This prohibition addressed the concern
that a bank's investment arm (where banks sell financial securities,
like stocks) could opportunistically sell low-quality investments,
and then use the proceeds to shore up bad loans from its commercial
arm (where banks take in deposits and turn out loans). However, by
decreasing the scope of activities in which banks could engage,
research has argued that it pushed out economical ways of producing
financial services. The costs of regulation, in this case, could
very well have outweighed the benefits.
Finally, regulation can work against the ability of financial
services to encourage capital to find productive uses. As described
in the previous section, research has found that historical
restrictions on banks opening new branches in other states decreased
the quality of loans. When banks make bad loans, financial capital
may not find its most productive use. Consistent with this argument,
state-level economies grew at faster and more stable rates after
they relaxed bank branch restrictions. box 9-2
---------------------------------------------------------------------
Safety and Soundness
Another policy concern, the financial system's safety and soundness,
has deep historical roots. Until the 1930s, the banking sector was
largely unregulated. As such, it was susceptible to bank runs,
whereby depositors raced to withdraw funds in anticipation that
others would do so first. Bank runs are problematic because banks
cannot quickly turn loans into cash in order to repay depositors.
Indeed, faced with a deposit run, a bank may be forced to sell loans
at a discount, which could leave depositors toward the end of the run
with little or no money.
To address this problem, the Federal government began to insure
deposits. Depositors have little reason to run on a bank when their
funds are guaranteed by the government. However, given that this
insurance can expose the U.S. taxpayer to potentially large losses,
the Federal government has an obligation to ensure that banks operate
in a safe and sound manner.
Federal banking agencies have sought to achieve safety and soundness
through supervision and the setting of capital requirements. Agencies
supervise banks much like banks would monitor their loan customers.
Bank capital requirements dictate the amount of capital or liquid
assets that banks must hold as a cushion against potential losses.
The Basel Accords
Capital requirements have found guidance over the past two decades
from two international agreements known as the Basel Accords. These
agreements were created under the auspices of the Basel Committee on
Banking Supervision (which is organized and operated by the G-10
countries) within the larger Bank for International Settlements
(BIS) located in Basel, Switzerland. The Basel Accords aim to produce
general principles and guidelines rather than promulgate binding law.
Basel I was instituted in 1988, and Basel II was issued in June 2004
(but has not yet been implemented). Basel II was designed to improve
upon its predecessor, Basel I, in the areas of risk management and
capital adequacy. And while the Accords are intended for large
international banks, a number of countries are using them to guide
domestic banking industries.
In addition to protecting depositors, Basel I and II aim to mitigate
global systemic risk: the risk that an event will trigger significant
adverse effects on the economy through loss of economic value and
confidence in the global financial system. Systemic risk is normally
associated with spillover effects, in which the original shock
spreads contagiously to other parts of the global financial system
and disrupts output and employment. The adverse effects of systemic
problems can arise from disruption of credit and capital flows. The
failure of a major international bank due to inadequate capital
financing provides one example of the type of "event" that could
trigger adverse shocks.
Prior to Basel I, countries operated under very different regulatory
capital regimes for their banks. Over time this arrangement raised
competitiveness and financial soundness concerns, prompting banking
supervisors in the industrialized countries to establish common
approaches to defining regulatory capital and setting minimum
regulatory capital requirements. Still, under Basel I, minimum
capital requirements can lack sensitivity to the underlying riskiness
of a bank's business activities. This encourages bank investments in
higher-risk assets for which regulatory capital charges are too low,
and fails to reward improvements in the bank's underwriting and
risk-management processes. The lack of risk sensitivity also reduces
the effectiveness of statutorily mandated, prompt corrective-action
policies in the United States, which are tied to a bank's regulatory
capital ratios. In recent years, financial innovations, such as
securitization and credit derivatives, and the greater sophistication
and complexity of risk-management techniques have rendered the
current regulatory capital framework, and related bank-reporting and
disclosure policies, increasingly outmoded for large, internationally
active banking organizations.
On September 30, 2005, the four Federal banking regulators (the Board
of Governors of the Federal Reserve System, the Office of the
Comptroller of the Currency, the Federal Deposit Insurance
Corporation, and the Office of Thrift Supervision) announced their
intent to issue in 2006 a Notice of Proposed Rulemaking for the U.S.
implementation of Basel II. The banking regulators plan to implement
only the so-called "advanced" Basel II approaches, under which
minimum capital requirements would be much more closely aligned with
a bank's actual risk taking by linking these requirements to the
bank's own internal risk assessments. This new framework introduces
three "pillars" intended to make reported regulatory capital ratios
better indicators of a bank's financial condition and to make a
bank's risk taking more transparent to both supervisors and the
general public. Pillar 1 sets a bank's minimum capital requirement
based on capital formulas whose basic inputs are derived from the
bank's internal risk-management systems. Pillar 2 establishes a
process through which supervisors and senior bank management will
review a bank's overall capital adequacy in relation to its business
activities and plans. Last, Pillar 3 attempts to enhance transparency
through requiring expanded public disclosures of a bank's risk
positions. Under the plan announced by the banking agencies, qualified
U.S. banks could begin transitioning to the advanced Basel II
approaches in January 2009.
Within the United States, only a few banks are expected to apply this
new framework. It will be mandatory only for the largest,
internationally active U.S. banks under the belief that the advanced
risk-measurement and management standards are most appropriate and
cost-effective for these institutions. However, any U.S. bank may
elect to adopt the new framework voluntarily. To address potential
competitiveness concerns that might arise from banks being subject
to different capital standards, the Federal banking agencies also
are considering possible modifications of the U.S. capital rules
that would apply to those banks not adopting the advanced Basel II
approaches. Broadly, such modifications would be designed to make
the rules applicable to the vast majority of banks more risk
sensitive, but without sacrificing overall simplicity of the current
capital framework.
As discussed above, capital standards for large banks are motivated
by the need to protect depositors and limit systemic risk. Concerns
about systemic risk extend beyond the traditional banking sector to
other sectors, such as government sponsored enterprises (GSEs).
Government Sponsored Enterprises (GSEs)
The Federal National Mortgage Association and the Federal Home Loan
Mortgage Corporation, more popularly known as Fannie Mae and Freddie
Mac, are two government sponsored enterprises (GSEs) that are
organized by the Federal government for the purpose of supporting
the secondary market for residential mortgages. The original
congressional intent behind the formation of these institutions was
to provide stability and liquidity in the mortgage market and to
promote home ownership, particularly among low-income families, by
reducing the costs of mortgages. (The government also pursues these
objectives through the Federal Home Loan Bank (FHLB) system.)
Fannie and Freddie primarily run two businesses: mortgage
securitization and portfolio management. In their securitization
program, Fannie and Freddie buy home mortgages from banks and other
mortgage loan originators, package them into pools, and sell claims
on these pools to investors as mortgage-backed securities (MBS). To
augment investor demand, Fannie and Freddie guarantee the interest
and principal on the underlying mortgages. These securitization
programs provide liquidity to mortgage markets by expanding the range
of investors who hold mortgage assets. The portfolio-management
function of Fannie and Freddie arises because they purchase and hold
MBS on their balance sheets. The combined assets on the balance
sheets of Freddie and Fannie rose from $132 billion (5.6 percent of
the single-family home-mortgage market) at the end of 1990 to $1.38
trillion (23 percent of the home-mortgage market) by 2003.
The market perception that the U.S. government backs GSE-issued debt
has facilitated the growth in Fannie and Freddie's portfolios.
Although GSE debt is not guaranteed by the government, the balance of
evidence suggests that most investors perceive that the Federal
government would step in to prevent a GSE default. This perception
allows GSEs to issue debt at an estimated 40 basis points (i.e., 0.40
percent) below the rates of their peer institutions. With access to
relatively inexpensive funds, the GSEs can easily finance expansions
of their portfolios.
The growth in GSE portfolios is accompanied by prepayment risk.
Prepayment of mortgages is problematic because GSEs tend to raise
funds at fixed interest rates, and prepayments tend to occur when
interest rates fall. Raising funds at fixed interest rates implies
that GSE debt issued to finance a purchase of mortgages is fixed
until the debt matures. However, if interest rates fall and, as a
result, prepayments occur, the GSEs must reinvest the funds from
the prepayment in the now-lower interest-rate environment. Typical
methods for hedging prepayment risk (without assuming additional
credit risk) include the use of interest-rate swaps to turn
fixed-rate debt obligations into floating-rate ones, and the buying
of Treasury securities. Both methods generate income when interest
rates fall, helping to offset the decline in income caused by
prepayments.
While all mortgage investors may face prepayment risk, the size of
the GSEs makes this risk of particular concern to financial markets
and regulators. Given the large size of their portfolios, it might
be very difficult for the GSEs to quickly adjust their portfolios if
hedges turned out to be less than perfect. The sudden failure of
one of these enormous providers of mortgage liquidity could severely
diminish the liquidity of the mortgage market and create severe
financial stress for holders of GSE securities. Prepayment risk is
also compounded by the low level of GSE capital. The capital-to-asset
ratios (measures of the financial cushion available to absorb
portfolio losses without becoming insolvent) of Fannie and Freddie
are roughly half the average capital-to-asset ratios at comparable
financial institutions.
The Administration's policy proposals have attempted to minimize the
systemic risks posed by GSEs, while preserving the benefits for
low-income home owners and the liquidity that GSEs provide to
mortgage markets. In particular, the Administration has proposed that
the GSEs focus on the business of mortgage securitization. As a
result, market liquidity will be enhanced for a wider range of
mortgages, and the home owner and liquidity benefits associated with
the GSEs will be maintained. Moreover, the resulting reduction in
the sizes of the portfolios will make the portfolios easier to hedge,
decreasing the likelihood of systemic problems with little adverse
impact on the liquidity of the market.  Indeed, at the behest of the
Office of Federal Housing Enterprise Oversight (OFHEO), Fannie's
portfolio has declined by $75 billion in the first half of 2005
without any noticeable effects on the MBS and home mortgage markets.
Apparently, there was ample MBS demand from other investors,
including banks and insurance companies.
The Administration has also recommended that regulators be allowed a
free hand in setting minimum and critical capital levels for the
GSEs, and that a clear and credible receivership process be
established for the GSEs. This extension of regulatory authority
should have little impact on the liquidity-generating activities of
the GSEs (i.e., their securitization activities), but would help to
mitigate the likelihood of systemic events.
Conclusion
Information tends to distribute itself asymmetrically--e.g.,
borrowers tend to have better information about how they will use
funds than do lenders. The potential to exploit such advantages
can stand in the way of mutually beneficial transactions. Financial
services are important for economic performance because they can
check this potential in an efficient manner. While they do not make
tangible goods, these organizations can play an integral role in
expanding economic possibilities.
Public policy can improve upon unregulated outcomes, but must do so
in a cost-effective manner. Moving too far on deregulation could
compromise consumer protection and system soundness. But moving too
far on public regulation can weaken economic performance. A
well-developed financial system is thus one that balances the costs
and benefits of public regulation. Systems like that in the United
States appear to have found this balance, and thus tend to support
strong economies.