Chapter 4: Executive Summary
What to Do About the Government Sponsored Enterprises?
Dwight Jaffee, Stijn Van Nieuwerburgh, Matthew Richardson, Lawrence White and Robert Wright
The primary function of the two government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, is to purchase and securitize mortgages. The securitized mortgages are sold off to outside investors with a guarantee of full payment of principal and interest. In addition, the GSEs hold some of the purchased mortgages as investments, and, in theory, help provide liquidity to the secondary market by repurchasing the mortgage-backed securities (MBS). They are major enterprises and play an unquestionably important role in the market for residential mortgages. The residential mortgage market is approximately 10 trillion dollars in size, 55% of which is securitized. The GSEs retain a mortgage portfolio of $1.5 trillion and have securitized (and thus guaranteed the defaults of) $3.8 trillion of existing mortgages. Though private institutions, the GSEs accept some regulatory oversight in return for an implicit government guarantee of support. As a result, the GSEs' activities are funded through "cheap" credit made available in capital markets under the presumed guarantee. The structure of the GSEs leads to the classic moral hazard problem in which the lack of capital market discipline and cheap credit provides an incentive for excessive risk taking. In fact, even though the GSEs' portfolio contained a variety of risks, including nonprime mortgages and long-maturity prime ones, the GSEs had leverage ratios of the order of 25 to 1.
The GSEs had two clear, negative influences on the financial system during the current crisis. The first was their investment in the subprime and Alt-A areas. By 2007, over 15% of their own outstanding mortgage portfolio was invested in non-prime assets, an amount representing 10% of the entire market for these assets. While not the only institutional culprit here, it is reasonable to assume that the mere size of the GSEs created "froth" and "excess" liquidity in the market. The second, and more important, effect was to introduce systemic risk into the system and therefore add to the growing financial crisis. This systemic risk came in three forms. First, by owning such a large (and levered) portfolio of relatively illiquid MBSs, the failure of the GSEs would have led to a fire sale of these assets that would in turn have infected the rest of the financial system, holding similar assets. Second, as one of the largest investors in capital markets with notional amount positions of $1.38 trillion and $523 billion in interest rate swaps and OTC derivatives respectively, the GSEs presented considerable counterparty risk to the system, similar in spirit to LTCM in the Fall of 1998. Third, the failure of the GSEs would have disrupted the firms' ongoing MBS issue/guarantee business, with major consequences for the US mortgage markets and obvious dire consequences for the real economy.
It is now clear, of course, that the fears of a systemic meltdown were all too accurate, and that the GSE model - combining a public mission with an implicit guarantee and a profit maximizing strategy - is untenable. Given that the GSE model itself is flawed, what is the appropriate reform to be followed? Consider the following series of questions and answers regarding mortgages:
© 2008 New York University Stern School of Business.