The government has become involved in financial intermediation in two basic ways: by setting up federal credit agencies that directly engage in financial intermediation and by supplying government guarantees for private loans.

Federal Credit Agencies

To promote residential housing, the government has created three government agencies that provide funds to the mortgage market by selling bonds and using the proceeds to buy mortgages: the Government National Mortgage Association (GNMA, or "Ginnie Mae"), the Federal National Mortgage Association (FNMA, or "Fannie Mae"), and the Federal Home Loan Mortgage Corporation (FHLMC, or "Freddie Mac"). Except for Ginnie Mae, which is a federal agency and is thus an entity of the U.S. government, the other agencies are federally sponsored agencies that function as private corporations with close ties to the government. As a result, the debt of sponsored agencies is not explicitly backed by the U.S. government, as is the case for Treasury bonds. As a practical matter, however, it is unlikely that the federal government would allow a default on the debt of these sponsored agencies.

Agriculture is another area in which financial intermediation by government agencies plays an important role. The Farm Credit System (composed of Banks for Cooperatives, Farm Credit banks, and various farm credit associations) issues securities and then uses the proceeds to make loans to farmers.

In recent years, some government financial intermediaries have experienced financial difficulties. The Farm Credit System is one example. The rising tide of farm bankruptcies meant losses in the billions of dollars for the Farm Credit System, and as a result it required a bailout from the federal government in 1987. The agency was authorized to borrow up to $4 billion to be repaid over a fifteen-year period and received over $1 billion in assistance. There is growing concern in Washington about the health of the federal credit agencies. To head off government bailouts like that for the Farm Credit System, the Federal Credit Reform Act of 1990 set new rules that require such agencies to increase their capital to provide a greater cushion to offset any potential losses. However, there have been growing concerns about Fannie Mae and Freddie Mac (see the Conflicts of Interest box, "Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches?").

Conflicts of Interest. Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches?

With the growth of Fannie Mae and Freddie Mac to immense proportions, there are rising concerns that these federally sponsored agencies could threaten the health of the financial system. Fannie Mae and Freddie Mac either own or insure the risk on roughly half of U.S. residential mortgages. In fact, their publicly issued debt of more than $2 trillion is nearly half that issued by the federal government. A failure of either of these institutions would therefore pose a grave shock to the financial system. Although the federal government would be unlikely to stand by and let them fail, in such a case the taxpayer would face substantial costs, as in the S&L crisis.

Concerns about the safety and soundness of these institutions arise because they have much smaller capital-to-asset ratios than banks. Critics also charge that Fannie Mae and Freddie Mac have become so large that they wield too much political influence. In addition, these federally sponsored agencies have conflicts of interest, because they have to serve two masters: As publicly traded corporations, they are supposed to maximize profits for the shareholders, but as government agencies, they are supposed to work in the interests of the public.

Both agencies have also experienced major accounting scandals recently. In 2003, Freddie Mac was accused by its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), of fiddling with its books in an effort to smooth out its earnings. The result was that Freddie Mac was forced to fire several of its top executives and pay a $125 million fine. Accounting irregularities at Fannie Mae also came to light in the fall of 2004, resulting in the resignation of Fannie Mae's CEO.

The accounting scandals and concerns about safety and soundness have led to calls for reform of these agencies. The George W. Bush administration and other government officials have argued that Congress should take steps to restrain the growth of Fannie Mae and Freddie Mac. One such approach would entail full privatization of these agencies, as was done voluntarily by the Student Loan Market Association ("Sallie Mae") in the mid-1990s. As private corporations they would lose the subsidies they receive as government-sponsored agencies and would be less likely to be bailed out, thereby increasing their cost of raising funds. Another approach would be to increase the ratio of capital to assets these agencies are required to hold—their regulator, the OFHEO, has recommended this route. Not only would an increase in the required capital ratio make Freddie Mac and Fannie Mae less likely to fail, but it would also require them to shrink the size of their asset base if they find it difficult to raise more capital. A third approach would be to directly limit the amount of certain assets they can hold. In February 2005, Alan Greenspan called for limits on the two agencies' holdings of mortgage securities, which expose them to substantial interest-rate risk, to around one-tenth of their current holdings.

Fannie Mae, which is legendary for its lobbying efforts in Congress, has argued that restricting its growth would lead to substantially higher housing costs for American homeowners. A study conducted at the Federal Reserve, however, estimates that the housing agencies probably save homeowners only about 0.07 of a percentage point, which comes out to $4.87 per month on a $100,000 mortgage—a trivial amount.

The recent accounting scandals have weakened Fannie Mae's and Freddie Mac's clout on Capital Hill, but it is not clear whether strong reforms will be enacted to cut them down to size.

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