Working Paper 2005-15 August 2005
Abstract: This paper studies the macroeconomic effects of implicit government guarantees of the obligations of government-sponsored enterprises. We construct a model with competitive housing and mortgage markets in which the government provides banks with insurance against aggregate shocks to mortgage default risk. We use this model to evaluate aggregate and distributional impacts of this government subsidy of owner-occupied housing. Preliminary findings indicate that the subsidy leads to higher equilibrium housing investment, higher mortgage default rates, and lower welfare. The welfare effects of this policy vary substantially across members of the population with different economic characteristics.
JEL classification: E21, G11, R21
Key words: housing, mortgage market, default risk
With close to 70% the United States displays one of the highest home ownership ratios in the world. Part of the attractiveness of owner-occupied housing stems from a variety of subsidies the government provides to homeowners. Apart from direct subsidies to low-income households via the U.S. Department of Housing and Urban Development (HUD) programs, three important indirect subsidies exist. The first - and most well known - is the fact that mortgage interest payments (of mortgages up to $1 million) are tax-deductible. Second, the implicit income from housing capital (i.e. the imputed rental-equivalent) is not taxable, while other forms of capital income (e.g. interest, dividend and capital gains income) are being taxed. Gervais (2001) addresses the adverse effects of these two subsidies within a general equilibrium life-cycle model. The third subsidy arises from the special structure of the US mortgage market. A large fraction of conventional conforming home mortgages in the US are being sold in the market with a guarantee provided by Government Sponsored Enterprises (GSEs) or purchased from individual banks for the GSEs' own portfolios. A formidable summary of the institutional details surrounding GSEs can be found in Frame and Wall (2002a) and (2002b). The three most important GSE are the two privately owned and publicly traded companies Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Association), and the FHLB (Federal Home Loan Bank system), a public and non-profit organization. According to Frame and Wall (2002a), citing a 2001 study by the Congressional Budget Office (CBO), Fannie Mae and Freddie Mac alone had a share of 39% of all home mortgages and a share of 71% among fixed-rate conforming mortgages.
The close link of GSEs to the federal government creates the impression that the government provides a guarantee to GSEs shielding them from aggregate risks, most notably aggregate credit risk which lowers their refinancing cost to below what private institutions would have to pay. The purpose of this paper is to quantify the macroeconomic and distributional effects of this subsidy; our paper is--to our knowledge--the first attempt to do so within a structural dynamic general equilibrium model.
According to Frame and Wall, GSEs enjoy an array of government benefits, for example a line of credit with the Treasury Department and very importantly a special status of GSE-issued debt. In particular, GSE securities can serve as substitutes to government bonds for transactions between public entities that normally require to be done in Treasuries. The Federal Reserve System also accepts GSE debt as a substitute for Treasuries in their portfolio of repurchase agreements. While no written federal guarantee for GSE debt exists, market participants view the special status of GSE debt as an indication of an implicit guarantee making them almost as safe as Treasury bills. The perception of a federal guarantee is further fueled by the sheer size of the GSE mortgage portfolio amounting to about 3 trillion dollars, 2. …