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CIAO DATE: 8/01
Leveraging Uncle Sam
On The Issues
April 2000
Recent legislation has permitted the Federal Home Loan Banks to get into small-business lending. This enlargement of authority allows Congress to avoid restrictions on new spending imposed by budget procedures and raises the same problems of uncontrolled growth and constituency-cultivation that are associated with Fannie Mae and Freddie Mac.
Does the United States, in the midst of a historic period of economic growth, need government-subsidized lending to small business? Despite all the attention given to the financial modernization law that President Bill Clinton signed last November, few have noticed that the bill authorized the Federal Home Loan Banks (FHLBs) to do just that. Particularly troubling is the larger trend: This is not the first time Congress has set up an off-budget mechanism to subsidize favored areas of the economy.
A New Charter
The FHLBs belong to the category of quasi-governmental entities known as government-sponsored enterprises (GSEs), the most prominent examples of which are Fannie Mae and Freddie Mac. The FHLBs are a kind of cooperative, formed originally to provide liquidity financing to member savings and loan (S&L) associations, and are thus part of the vast subsidy system Congress created to encourage home ownership in the United States. Although their securities are not officially backed by the full faith and credit of the U.S. government, the FHLBs are able to borrow in the capital markets at better than triple-A rates because investors believe Uncle Sam would not allow them to fail. So far, the investors have been correct. Whenever a GSE has encountered financial trouble, Uncle has made everyone whole (the most recent example is the Farm Credit System in the 1980s).
When the S&L industry collapsed in the late 1980s, however, the FHLBs were in danger of losing their mission. The remaining S&Ls had financing needs, to be sure, but the business of housing finance had by then expanded well beyond a single set of specialized institutions. In reality, the industry no longer needed a GSE liquidity lender—if it ever did—and Congress should have abolished the FHLBs. But even the Republican Congress, while talking bravely about cutting the size of government, could not bring itself to administer a coup de grâce to the FHLBs. Instead, these institutions were allowed to extend their subsidized financing to commercial banks—again in support of housing—and this lending has grown over time as commercial banks have enjoyed the subsidy implicit in the FHLBs' favorable rates.
Nevertheless, confining the FHLBs to housing finance was unsatisfactory to them. The housing market grows about six percent a year, and the portion of that growth that is picked up by their member banks and S&Ls is less than that (because not all mortgage lenders are members of the FHLB system). This was not a sound basis for long-term expansion. What the FHLBs needed was a new mission—something they could use to justify their existence indefinitely.
And sure enough, something turned up. As Congress tried to pass the financial modernization bill last year, it was accused of working to help large banks but doing little for the thousands of small institutions that for almost two centuries had called the tune in U.S. banking policy. So the FHLBs were authorized to finance small bank lending to local small business and agriculture. This move secured the support of the small banks for legislation that primarily benefited their larger cousins, and it gave new life to an agency that should have been abolished in the first place.
A Large and Troubling Trend
But this is more than a routine resuscitation of a government agency. The creation of a specialized financier for small business lending is part of a much larger and more troubling trend: Congress establishes a GSE, and the GSE, once established, assembles constituencies that benefit from its subsidies and that lobby to keep them growing and unimpaired. Depending on the size and wealth of its constituency, a GSE can acquire a kind of invulnerability to congressional scrutiny. Fannie Mae and Freddie Mac, for example, have made themselves virtually untouchable by parlaying their own enormous wealth and the political power of their housing constituencies.
Both have maintained their positions by providing substantial soft money contributions to both major political parties ($1.3 million in the last election cycle), and their large and well-compensated executive group makes hard money contributions to key lawmakers.
Beyond all that, they hire legions of lobbyists, open offices in congressional districts, make contributions to the favorite community groups of influential congressmen and senators, and hold campaign fund-raisers to which they invite their constituents—the homebuilders, realtors, lenders, and securities underwriters who profit from their purchases of mortgages and their issuance of securities.
These activities enable Fannie and Freddie, which carry serious financial risks, to manage political risk—the danger that Congress might try to regain control of their activities. Hence, the top officers of Fannie are not experts in housing or finance but are best known for their political networks.
These agencies are, in other words, literally "out of control." And this lack of control by either Congress or the executive branch has introduced government-backed competitors into the non-subsidized private sector and created large risks for the taxpayer: Fannie Mae and Freddie Mac, both originally charged with keeping the mortgage markets liquid by buying and selling mortgages, have become the largest S&Ls the world has ever seen, doubling in size every five years since 1970.
By the end of 1998, they had assumed mortgage risks of almost $1.8 trillion and, if growth forecasts are accurate, will bear $3 trillion of mortgage risk by 2003. At that point, they will be at risk either as holders or as guarantors for almost half of all residential mortgages in the United States. Because they have the implicit backing of the United States government, this means that taxpayers will be standing behind $3 trillion of risk that could and should have been lodged in the private sector alone.
With their broad charters, and in the absence of serious political oversight, Fannie and Freddie have used their government-supported financing to move into housing-related sectors of consumer finance, offering government-subsidized credit for home improvements and home fixtures such as efficient heating systems. Many believe that this is just the beginning of what will eventually become a full-fledged consumer finance business.
It is not unusual for constituencies to form around government programs, of course, but the GSEs are different. Because they are off-budget and are financed by trading on implicit government credit support, they are not subject to the scrutiny and competition that all other government programs must endure.
Under current budget rules, if Congress wants to start or expand a program it must increase taxes or find offsets. This places all on-budget programs in competition with one another. Even on-budget federal guarantee programs are subject to this discipline, since budget rules require that the guarantee's value be included in the budget as though it were an appropriated sum.
GSEs such as Fannie and Freddie do not encounter this problem. Since they are not funded through appropriations or included in the federal budget, they get very little congressional oversight. The appropriations committees are too busy with on-budget items, and the authorizing committees have no need to revisit the broad charters under which the GSEs generally function. These factors, plus their wealth, the generosity of their constituencies, and the strength of their political networks in Washington, D.C., allow them to fight off political control. Even more important, as long as they are left without oversight or political restriction, their off-budget, market-based funding allows them to expand indefinitely without having to go back to Congress. In other words, favored constituency groups get benefits for which congressmen and senators can claim credit, but there is no need for new taxes or offsets that might put them into competition with other congressional priorities.
Trouble Ahead
That is why the new authority of the FHLBs is so troubling. It represents another step in a process that is gradually placing more and more government activity outside the control of Congress, the executive branch, and ultimately the voters. Where Fannie and Freddie have been able to exploit the politically charged mantra of their association with housing, the FHLBs will be able to exploit their association with small business—another powerful constituency.
Yet even responsible members of Congress are showing no awareness that they are creating a Frankenstein monster. The managements of many federal financial programs, however, will not miss this point. The absence of congressional oversight, and the lure of the enormous salaries and stock-option-driven compensation enjoyed by the managements of Fannie and Freddie, are likely to be irresistible to the managements of the many government agencies now on-budget. They will soon point out to Congress the great advantages that can be gained by turning their own agencies into GSEs. Unless someone in Congress recognizes this trend, in the future we will see more and more governmental activity move off-budget—off budget and out of control.
Peter Wallison is a resident fellow at the AEI. This article appeared in the March/April 2000 issue of the International Economy and is reprinted with permission of that magazine.
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