Fannie and Freddie Concern Fed

Two articles by Patrick Barta in the Wall Street Journal chronicle the rising concerns about Fannie Mae and Freddie Mac. Expect closer scrutiny by economists and policymakers in the months ahead.

Chartered by the government; the two firms were expected to and have succeeded in improving the flow of funds to the mortgage market. However, some accounting issues have arisen recently. The basic concerns are with the valuation of derivatives. "A derivative is a financial contract derived from an underlying security, commodity, interest rate, or currency." It can also involve an option to buy or sell securities. The accounting issues involved are complex, but they apparently were involved in Freddie Mac's recent announcement that it planned to restate its earnings for 2002, 2001, and possibly 2000. The day after the announcement, the firm's stock price fell 11 percent.

The accounting debate has focused more attention on the economic role than on the economic justification for Fannie Mae and Freddie Mac. The most recent article by Barta notes "a prominent Federal Reserve policy maker warned of a potential 'crisis' if steps aren't taken to rein in the rapidly expanding mortgage companies." The firms are chartered by the government and "own or guarantee $3.1 trillion in mortgages or 45% of all residential debt outstanding in the U.S., compared with 25% as recently as 1990." Most importantly, the two firms have lines of credit at the Treasury. This government funding lowers the firms' cost of capital and has enabled them to dominate the home mortgage funding market. Their accounting and risk management practices may or may not pose a growing risk. However, there is no denying that the massive amount of funds provided by the two quasi-government agencies has provided an important boost the housing market and, in turn, the economy. It would be very difficult for the housing market to "break the habit" of relying on the funds provided by these two firms.