In addition to the three branches of government, there are a large number of “Independent Agencies” and “Government Sponsored Entities” that play a very important role in the US. While all have been established under laws, they differ in terms of governance, ownership structure and their reliance on the government for funding.
The Federal Reserve Bank
The single most important independent agency is the Federal Reserve System (the “Fed”), the central bank that was established in 1913 after successive waves of banking panics. The Fed has a government mandate to 1) maximize employment, 2) stabilize prices, and 3) maintain moderate long-term interest rates.
The principal tool used by the Fed is the power to set short term interest rates in the US banking system. To strengthen a weak economy, the Fed will lower interest rates to incentivize higher lending volumes. To cool down an overheated economy, they do the reverse. A more recent tool was Quantitative Easing, whereby the Fed buys assets (various types of bonds) from banks leaving the banks with plenty of cash with which to make loans. The Fed also regulates and supervises commercial banks across the US.
The Fed, together with the Treasury Department, is the lender of last resort in the banking system.
The US has a fractional reserve banking system. For every $100 of deposits made to a bank, only a small fraction (say 10%) is held in reserve to repay deposits and the balance is invested in loans which won’t be repaid for years. As a result, if all depositors in a bank were to withdraw their deposits on a single day, the money simply wouldn’t be there. Before the Fed, panics frequently caused banks to go under and depositors to loose their money. If a panic occurs now, the Fed stands ready to lend the bank the money necessary to meet deposit withdrawals.
The Fed consists of a Board of Governors with 7 members appointed by the President. The Fed Governors have 14-year terms to help assure they act independently from any particular President’s political agenda. There are 12 regional Federal Reserve Banks, which are owned by the banks within the particular region. The President of a regional Federal Reserve Bank in selected by the board of directors of the bank (excluding directors who are employed by banks being supervised by the Fed) subject to the approval of the Board of Governors. So, there is mix of private and public influence in the selection of Federal Reserve Bank Presidents.
The key policy arm of the Fed is the Federal Open Market Committee, which basically sets interest rate and monetary policy for the country. This committee consists of the entire Board of Governors and the 12 regional bank Presidents, although only 5 regional bank Presidents are permitted to vote (the right to vote rotates among the 12 districts).
The Fed is entirely self-financed and fully independent of the US government. Its profits, after certain dividends to commercial bank shareholders, are fully contributed to the US. The Fed gave $97.7 billion of profits to the US Treasury in 2015.
The independence of the Fed is critical to the stable operation of the country’s economy and banking system. First, the pressure of two-year election cycles in the House of Representatives makes congress incapable of setting the country’s monetary policy. The prospect of Super PAC influence makes this unthinkable.
Second, financial panics often require very quick and controversial actions, such as forcing banks to raise capital, forcing weak banks to merge with strong banks, bailing out banks with Fed money or letting banks, like Lehman Brother, go completely belly-up, all in the course of a weekend. Elected officials are not good at quick, decisive and controversial actions that may anger prospective voters or particular industry lobbyists.
The Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (the “FDIC”) is another independent agency central to the US banking system. The FDIC guarantees individual bank and savings & loan deposits up to $250,000. It also takes over failed banks and unwinds them.
There is a long history of bank failures in the US, so making deposits in excess of the $250,000 FDIC guarantee limit should be very carefully considered. Banks pay insurance premiums to the FDIC for the deposit guarantees and, absent a financial crisis; the FDIC operates at a profit.
The Pension Benefit Guaranty Corporation
If the Fed and FDIC exist because of bank failures, the Pension Benefit Guaranty Corporation (PBGC) exists because of corporate and business failures. This entity takes over bankrupt defined benefit pension plans from the private sector and guarantees that the members receive pensions.
Single employer and multi-employer plan participants pay an annual PBGC insurance premium. The PBGC also takes over the assets of failed pensions and takes aggressive actions to recover any deficits from the sponsoring company, often in bankruptcy court.
They use the insurance premiums, pension assets and investment income on the assets to fund annual pension benefit payments, The payments may or may not be equal to the amount a retired employee would have received had the plan not gone bankrupt, which are determined annually by the government. In 2015, the PBGC reported a $239 billion contingency for possible losses.
The Social Security Administration
Another key independent agency is the Social Security Administration, which is a government sponsored insurance program for retirement, disability and survivor benefits. There are two basic sources of revenues supporting this program: payroll taxes and interest earned on the Social Security Trust Funds. Given the importance of Social Security, The Informed Vermonter will cover its operations in a separate article.
Other independent agencies of the US government include the US Postal Service, Small Business Administration, Securities and Exchange Commission, Peace Corps, National Security Agency (they spy on our e-mails), Nuclear Regulatory Commission, Federal Trade Commission, Environmental Protection Agency and the CIA.
There are also some important government sponsored entities, or “GSE’s”. All of these entities have been established to improve credit markets for some specified activities. The key sectors are housing loans, agriculture and, until 1995, student loans. These entities don’t make direct loans, but instead provide liquidity to the banks that do make such loans either through lending to the banks or, more frequently, buying bank loans in bulk and repackaging them for the securitization markets.
Fannie Mae and Freddie Mac
Two of these entities are worthy of further discussion. The Federal National Mortgage Association (“Fannie Mae”) was established in 1938 as part of the New Deal. By 1970, it was set up as a fully private entity with no government support to purchase mortgage loans from banks and provide liquidity to the mortgage loan markets. Basically, they buy thousands of individual mortgages and either hold them on their books or repackage them into securitizations for resale to the bond market. These securitizations are guaranteed by Fannie Mae, but not the by the US government. In 1970, congress created the Federal Home Loan Mortgage Corporation (“Freddie Mac”), again a fully private company, to simply compete with Fannie Mae. It does the exact same thing.
Up until 1992, Fannie Mae and Freddie Mac had very conservative underwriting standards for the mortgages they stood willing to buy from banks. “Conforming” loans had to be 80% loan/value or less, not above certain sizes and the income of the borrower need to pass certain thresholds. In 1992, the US passed a law making it an affirmative obligation of Fannie Mae and Freddie Mac to facilitate mortgage lending to low and middle-income families. In 1999, another US law required them to begin supporting mortgage lending in distressed inner city neighborhoods.
By 2006, loan/value ratios in excess of 80% and jumbo loans were being underwritten and they were actively buying sub-prime mortgages. The credit quality of their portfolios began to deteriorate. You know where this story is going.
For years, Fannie Mae and Freddie Mac had a duopoly on the mortgage secondary market. By 2000, private label Mortgage Backed Securities (“MBS”) created by investment banks like Lehman Brothers began to compete by selling MBS that was not guaranteed by Fannie Mae or Freddie Mac. The private label market drove mortgage credit standards to all-time lows and created a massive sub-prime mortgage market in the US. By the end of 2007, this all began to fall apart and the housing market crisis began in earnest. With default and foreclosure rates soaring, housing prices collapsed.
While Fannie Mae and Freddie Mac didn’t cause the housing crisis, they certainly contributed to it. The US government directly facilitated more aggressive lending standards to meet their political objectives and by 2006, competitive pressure from the private label market drove these standards even lower.
In 2008, Fannie Mae and Freddie Mac both needed to be bailed out by the US Government, which took a 79.9% ownership interest in return for the money.  Over half of all US home mortgages are either held directly or guaranteed as part of a MBS by Fannie Mae and Freddie Mac. Their combined portfolios are about $5 trillion. Given their predominant role in the US market, the government had no option but to bail these two GSE’s out.
Fannie Mae and Freddie Mac are both now on the road to recovery. They still have lots of bad loans to work out, but the overall quality of their portfolio is improving. Importantly for taxpayers, by 2015 both had paid dividends to the government that fully repaid taxpayer money. While the money has been repaid, the commitment to provide it again remains in place.
 Financial Report of the United States Fiscal Year 2015, U.S. Government Accountability Office, February 25, 2016, 75
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 Financial Report of the United States Fiscal Year 2015, U.S. Government Accountability Office, February 25, 2016, 92
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