Academic journal article Real Estate Economics

The Value of Federal Sponsorship: The Case of Freddie Mac

Academic journal article Real Estate Economics

The Value of Federal Sponsorship: The Case of Freddie Mac

Article excerpt

Losses imposed on the taxpayer as a result of the financial collapse of the Farm Credit System and the Federal Savings and Loan Insurance Corporation (FSLIC) and the need to recapitalize the FDIC have increased the awareness of and concern over financial guarantees issued by the federal government. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) required the Congressional Budget Office, the General Accounting Office (GAO), the Office of Management and Budget and the U.S. Treasury to evaluate the risk posed to the federal government and the taxpayer by the operations of Government Sponsored Enterprises (GSEs). While this did not affect, in any way, the operations of GSEs, it did serve to address the question of the magnitude of the potential problem.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (FHEFSSA) is the first, and so far the only, positive step taken to limit the risk imposed on the taxpayer by GSEs, in this case the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae). Both entities are central players in the secondary market for conventional mortgages. In 1993, their combined activities accounted for 54.0% of conventional residential mortgage financing. This was down from 64.0% in 1992 and up from 51.0% in 1991. Their relative shares for 1993 were 45.0% for Freddie Mac and 55.0% for Fannie Mae. Freddie Mac's share has risen from 44.0% and 43.0% in 1992 and 1991. Given the implicit federal guarantees that accompany their status as GSEs, they have very little competition in the market for securitizing conventional mortgage loans that conform to their underwriting standards / limitations.(1)

This article develops a general methodology for assessing the magnitude of the risk imposed on the federal taxpayer by any GSE, applies that methodology to the FHLMC and examines the sensitivity of that risk to changes in Freddie Mac's capital base. The results indicate that: (1) the new control standards lower the level of risk; (2) the level of risk is modestly sensitive to the degree of capitalization; (3) complete privatization of Freddie Mac (and, by implication, Fannie Mae) will raise costs only slightly but possibly by enough to permit additional private sector competition; and (4) while the implicit guarantee of Freddie Mac results in rather small subsidies given normal markets for real estate, the losses to the federal government and, therefore, the value of the guarantee rises substantially in the event of a severe recession in which the market value of real estate falls appreciably.

A Primer on Freddie Mac

A government sponsored enterprise, as defined in the Omnibus Budget Reconciliation Act of 1990 (OBRA), is a private corporation that operates under a charter granted by the Congress of the United States. The preponderance of its board of directors is elected by private shareholders, though some portion may be appointed by Congress or the president. It's central function is to serve as a financial intermediary, making loans or issuing loan guarantees to borrowers or sectors identified in the enabling legislation as being inadequately served by private markets. Funds may be raised in a variety of ways, but in no case are the liabilities of the GSE explicitly backed by the full faith and credit of the federal government.(2) In spite of this disclaimer, every GSE is perceived by the credit markets as having an implicit federal government guarantee backing its obligations. In addition, GSEs benefit from one or more explicit regulatory preferences such as federal tax exemptions, exemptions from SEC regulations and access to the U.S. Treasury for a line of credit. Since GSEs generally compete directly with privately owned firms where the implied credit guarantee and other exemptions amount to subsidies, the GSEs have a competitive advantage of uncertain magnitude over private competitors. …

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