The Effect of Housing Government-Sponsored Enterprises on Mortgage Rates

Article excerpt

We derive a theoretical model of how jumbo and conforming mortgage rates are determined and how the jumbo-conforming spread might arise. We show that mortgage rates reflect the cost of funding mortgages and that this cost of funding can drive a wedge between jumbo and conforming rates. Further, we show how the jumbo-conforming spread widens when mortgage demand is high or core deposits are not sufficient to fund mortgage demand, and tightens as the mortgage market becomes more liquid and realizes economies of scale. Using Mortgage Interest Rate Survey data for April 1997 through May 2003, we estimate that the government-sponsored enterprise funding advantage accounts for about 7 basis points of the 15-18 basis point jumbo-conforming spread.

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Congress created two government-sponsored enterprises (GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), with the goal of providing banks, thrifts and other mortgage originators with a liquid secondary market that would provide an alternative to funding mortgages with deposits. A secondary mortgage market allows mortgage originators to respond more quickly to fluctuating mortgage demand and to lower mortgage rates for some homeowners when mortgage demand is high.

When Congress created the GSE charters, they provided the GSEs with a variety of special benefits. (1) Initially, many viewed these benefits as a way to enhance the GSEs' efforts in establishing a secondary mortgage market. However, with the secondary mortgage market well established and with many other well-functioning purely private secondary markets, the justification for the GSEs' benefits has shifted to the GSEs' success in lowering mortgage rates and in encouraging affordable housing.

The GSEs benefit from the government-sponsored status because purchasers of their debt assume that the government will not allow the GSEs to fail, even though the government has made no explicit promise to bail out the GSEs should problems arise. This ambiguous government relationship creates an implicit government subsidy to the GSEs that is worth billions of dollars (CBO 2001). In this article, we estimate the proportion of this implicit subsidy that GSEs transmit to homeowners via lower mortgage rates.

Like many previous studies, this article focuses on the difference in mortgage rates observed on mortgages that exceed the size limit imposed on GSE mortgage purchases (jumbo mortgages) and mortgages below this size limit. Many previous studies assume that the spread between jumbo and conforming mortgage rates is a measure of the effect of GSEs. This assumption ignores segmentation of the jumbo securitization market as well as the effects of bank funding capacity, banks' investment alternatives and fluctuating mortgage demand on mortgage rates. When one considers a hypothetical world without GSEs, researchers need to consider both the possibility that conforming rates will rise and that jumbo rates will fall. Currently, the jumbo mortgage securitization market is artificially segmented from the conforming market because of the conforming loan limit, and it therefore cannot realize the economies of scale or scope of the conforming mortgage-backed securities (MBS) market. (2) Thus, the jumbo-conforming spread is an upper bound on the extent to which mortgage rates might rise if GSEs lost their special status. Our research suggests that the typical jumbo-conforming spread is between 15 and 18 basis points and that the GSE funding advantage likely accounts for about 7 basis points of this difference.

The Effect of the GSE Implicit Subsidy on Mortgage Rates

Given the many intermediaries between the source of the subsidy (investors who view the GSEs as backed by the government) and the target of the subsidy (homeowners), the GSEs' presence does not necessarily change mortgage rates very much. As argued by Goodman and Passmore (1992) and Hermalin and Jaffee (1996), much of the subsidy may not be transmitted to homeowners. …