Bubble bubble mortgage trouble: have the GSEs created a clear and present danger to the U.S. financial system, the economy, and the dollar?

• Author: Noland, Doug
• Position: Government-sponsored enterprises

Back in 2000, I wrote an article for The International Economy titled "The Great Experiment." The locus of the analysis was the nuances of contemporary finance, in particular the ramifications for unchecked growth from the government-sponsored enterprises (GSEs). Four years later, sufficient data and observations from this "experiment" warrant an update and further analytical examination.

From January 2000 through May of this year, Fannie Mae and Freddie Mae's combined "books of business" (retained portfolios and guaranteed mortgage-backed securities sold into the marketplace) have ballooned 77 percent to $3.66 trillion. Fannie and Freddie total assets have increased 186 percent to $2.83 trillion since the beginning of 1997, with Federal Home Loan Bank System assets up 193 percent to $857 billion. And according to Federal Reserve "flow of funds" data, total mortgage debt has increased 93 percent to $9.62 trillion, jumping from 61 percent to 84 percent of GDP in seven years.

Total mortgage borrowings expanded $1.0 trillion or 12 percent last year, with 2004 on track to surpass 2003's record. For comparison, mortgage debt increased on average about $200 billion annually during the first eight "pre-bubble" years of the 1990s. Total U.S. home sales are currently on track to surpass last year's record by 10 percent, with the dollar value of housing transactions up approximately 65 percent over three years and 100 percent from six years ago. The nation's average (mean) price of existing homes sold has increased 28 percent over three years and 48 percent over the past six years. In California, median home prices were up an astonishing $97,530 during the past twelve months (through May) to $465,160. Golden State home prices have surged 46 percent over two years, 81 percent over three years, and 129 percent over six years, in what has developed into one of history's spectacular asset inflations.

The GSEs have played the instrumental role in the development of a historic mortgage finance bubble. And while the GSE debate tends to concentrate narrowly on the values of the federal subsidy and the implicit government backing of agency debt, the broader and crucial--issue of the consequences of a momentous expansion of mortgage finance is neglected, if at all recognized.

Reminiscent of the late- 1990s manic stock market environment, the issue "Is housing a bubble?" has become a hot topic for the media, investment analysts, economists, and policymakers. Federal Reserve Bank of New York economists Jonathan McCarthy and Richard W. Peach recently published "Are Home Prices the Next 'Bubble'?" This research suggests that, in spite of significant attention directed to the issue of asset bubbles, our central bank has made scant progress in comprehending or addressing either asset inflation or bubble dynamics.

Messrs. McCarthy and Peach concluded that "there is little evidence to support the existence of a national home price bubble." Yet, their article--and Federal Reserve research generally--ignores what should be the focal points of bubble analysis: credit growth, speculative finance, marketplace liquidity, and various financial and economic distortions.

Analyses of the GSEs and mortgage finance should begin with an appreciation for the extraordinary capacity of key lenders these days to issue unlimited quantities of new liabilities (chiefly, agency and asset/mortgage-backed securities) with no impact on the market's perception of these instrument's "Triple-A" quality status. Indeed, it is a defining characteristic of contemporary Wall Street "structured finance" that virtually inexhaustible quantities of risky loans can be transformed into perceived top-quality, safe and liquid securities. This alchemy is dependent upon a daisy-chain of explicit and implicit guarantees, credit insurance, liquidity agreements, and the expansive derivatives marketplace. The GSEs are very much the nucleus, while the market's faith in the Fed and Treasury to stand behind Fannie, Freddie, and the FHLB provides the backbone of this peculiar market structure.

From a theoretical perspective, financial evolution has attained a renown I will refer to as the "moneyness of credit"--a pinnacle achievement conceptually...