1. law, govt and politics
2. government

J. OF PUBLIC BUDGETING, ACCOUNTING & FINANCIAL MANAGEMENT, 11(1), 81-116
SPRING 1999
ESTIMATING AND MANAGING THE FEDERAL SUBSIDY
OF FANNIE MAE AND FREDDIE MAC:
IS EITHER TASK POSSIBLE?
Ron Feldman*
ABSTRACT. Fannie Mae and Freddie Mac receive explicit and implicit off-budget
subsidies from the federal government. This paper reviews the methods to estimate the dollar
amount of the subsidies. None of the three techniques to estimate the indirect subsidy yield
accurate point estimates. They do suggest that Fannie and Freddie could receive billions of
dollars in subsidies in some years and much smaller amounts in other years. However,
assessing the size of the implied subsidies is most valuable in demonstrating that Fannie and
Freddie, not the federal government, control their size. Efforts to improve federal control
face significant difficulties including informational asymmetries and the political incentives that
have led to the status quo. These drawbacks bolster the rationale for eliminating federal
support for Fannie and Freddie.
INTRODUCTION
The thrift industry debacle focused analytical and political resources on
the contingent liabilities and implicit subsidies of the federal government. The
Congress, for example, required several agencies in 1989 and 1990 to assess
the risks undertaken by government sponsored enterprises (GSEs) that are
implicitly borne and subsidized by taxpayers. (1) GSEs are privately owned,
federally chartered corporations that operate nationally with specialized
lending powers. Fannie Mae and Freddie Mac are the two largest GSEs and
funders of one- to four-family mortgages in the United States. The studies
were followed in 1992 by a
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* Ron Feldman is a senior financial analyst with the Banking Supervision Department
at the Federal Reserve Bank of Minneapolis.
Copyright © 1999 by PrAcademics Press
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Congressional mandate to evaluate the desirability and feasibility of
eliminating Fannie and Freddie’s implicit federal support. (2) Given the
attention generated by these inquiries, it is not surprising that a body of
literature estimating the size of the subsidy that Fannie Mae and Freddie Mac
enjoy developed over the last fifteen years. This article reviews the subsidy
literature.
Fannie and Freddie do not receive their subsidies through on-budget
federal appropriations. Instead they receive explicit, but off-budget, subsidies
through means such as exemptions from certain fees and taxes. They receive
much larger implicit, off-budget subsidies through perceived, but not legal,
credit support from the federal government. Subsidy estimates vary with the
most recent set of calculations putting the total subsidy for both firms at about
$6 billion for 1995. Methods of estimating the implicit subsidy include
determining the net market value of Fannie and Freddie’s balance sheet assets
and liabilities and contrasting it with their market capitalization, modeling the
implicit support provided to Fannie and Freddie as a put option, and
comparing the yields on Fannie and Freddie’s securities to the yields on
similar securities issued by firms without GSE status. Estimating how much
Fannie and Freddie have lowered rates on conforming mortgages also
provides an indirect method for valuing the implicit subsidy. These methods
have significant weaknesses and valuations of the GSE subsidy should not be
considered accurate point estimates. Instead, these calculations provide
valuable order of magnitude estimates and evidence that the subsidy could be
quite large. The estimating techniques also indicate that Fannie and Freddie
control the value of the subsidy and that the federal government has virtually
no idea about the level of public resources it provides Fannie Mae and
Freddie Mac at the time they receive the subsidy.
Federal deficiencies in managing the GSE subsidy are no secret. As a
result, analysts have also suggested a variety of methods for controlling its
size. These techniques include requiring additional disclosure of the subsidy,
levying fees on the use of the implicit guarantee, requiring that Fannie and
Freddie maintain high bond ratings, restricting the amount and type of
business they can conduct, and making the social goals they must meet more
stringent. A standard method for controlling risk, prudential capital standards,
are currently under development. Methods of subsidy management face
serious obstacles given the huge informational advantage and political
influence the two firms maintain. The benefit of providing firms with indirect
subsidies only to devise methods to reduce the value of subsidies or to
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redirect them is also questionable. The difficulties that the government faces
in obtaining information on the GSE subsidy and managing it provide
additional justification for considering its elimination.
The first section of this article provides a very brief background on the
two housing enterprises. The second section summarizes research estimating
the size of subsidy, identifies weaknesses with these methods and discusses
the benefits of conducting such estimates. The third section briefly reviews
some recommendations for managing the subsidy and highlights two
important reasons why these methods may not to be completely effective. A
conclusion summarizes the findings.
BACKGROUND ON FANNIE MAE AND FREDDIE MAC(3)
The Congress charters GSEs to correct perceived failures in private
credit markets. The private benefits GSEs provide policy makers, such as
campaign contributions, are discussed later. The Congress created Fannie
Mae and Freddie Mac specifically to intermediate funds between national
capital markets and local mortgage markets. This intervention seemed
necessary, in part, because other federal policies including prohibitions on
interstate banking and branching and limitations on banks’ ability to pay
market rates for deposits contributed to regional shortages of funds available
for mortgage lending. Fannie and Freddie’s most common method of
intermediating funds involves the securitization of mortgages. Usually, the
agencies will receive a pool of mortgages from a seller and, in exchange, swap
mortgage-backed securities (MBS) backed by that same pool. The
enterprises earn a fee equal to the difference between rates paid on the
underlying mortgages and rates paid on the MBS. Fannie and Freddie
guarantee the payment of principal and interest on the mortgages underlying
their MBS. Both agencies also engage in portfolio lending in which they
purchase mortgages to hold, fund the purchase via issuance of unsecured debt
and profit from the spread. Fannie and Freddie have been successful in
limiting regional fund shortages; their intermediation has integrated national
capital markets with local mortgage markets (Hendershott and Van Order, 1989).
Fannie and Freddie’s current legislative mission focuses on providing
stability and liquidity in the secondary market for residential mortgages. (4)
The breadth of the firms’ operations to achieve that goal is enormous. As of
year end 1996, about $1 trillion in Fannie and Freddie MBS were outstanding
and the firms held $424 billion of mortgages in portfolio (5) (Fannie Mae,
1996a; and Freddie Mae, 1996a). By way of comparison, Fannie and
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Freddie financed more of the mortgages outstanding as of year end 1996 than
the entire commercial banking system and had as much debt outstanding as
all state and local governments (Board of Governors of the Federal Reserve
System, 1996a; 1996b).
Fannie and Freddie are prevented from originating mortgages in carrying
out their missions. The enterprises also cannot finance mortgages whose
original principal amount exceeds the “conforming limit”, $214,600 in 1997,
although the firms will have access to over 75 percent of all new mortgage
originations under this limit (Nyhan, 1996). In addition, they cannot finance
mortgages with loan-to-value ratios of greater than 80 percent unless an
acceptable credit enhancement is offered. The enhancement usually takes the
form of mortgage insurance. Finally, the firms can only purchase mortgages
that meet the standards of private institutional mortgage investors. The
enterprises are also less active in financing non-conventional mortgages, those
insured by the federal government through the Federal Housing
Administration (FHA) or the Department of Veterans Affairs (VA), because
they are at a cost-disadvantage relative to the Government National Mortgage
Association (GNMA). GNMA securitizes non-conventional mortgages and
guarantees MBS with the full faith and credit of the U.S. Treasury.
The Congress subsidizes Fannie and Freddie in support of their
missions. Part of the subsidy is explicit. The enterprises do not have to pay
state and local income tax on their earnings. The securities of Fannie and
Freddie are also exempt from the Securities and Exchange Commission’s
(SEC) registration process. Finally, both firms have a free back-up line of
credit (LOC) of $2.25 billion from the Department of Treasury. Most
attention, however, has focused on their implicit subsidy. Lenders believe
that the federal government would make good on the enterprises’ financial
obligations even though the federal government rejects any legal responsibility
for these debts. The commitment of the Congress to the enterprises’ mission,
the federal government’s previous financial support of GSE debt, and the
intentional similarity between GSE securities and Treasury securities lead
investors to act as if the credit of the U.S. Department of Treasury (1996)
supports GSE securities. (6)
The implicit subsidy benefits Fannie and Freddie in a number of ways.
First, it reduces their cost of raising funds. This reduction can be
characterized in terms of borrowing rates or capital and credit enhancements.
Given their level of capital, the implicit guarantee allows Fannie and Freddie
to raise funds on the debt and MBS markets at a lower rate than would
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otherwise be available. Alternatively, because of the implicit guarantee,
Fannie and Freddie do not have to incur the cost of capital or credit
enhancements that they would otherwise have to in order to borrow at their
current rates. In addition, federal implicit support provides bank regulators
with the comfort to allow insured depositories to hold less capital against
Fannie and Freddie MBS than they do against private MBS. This raises the
price that banks are willing to pay for GSE MBS and thus lowers Fannie and
Freddie’s cost of funds.
Second, the implicit subsidy gives Fannie and Freddie almost guaranteed
access to capital markets regardless of their solvency. Fannie and Freddie
would not face the credit rationing that other firms in weak financial condition
may meet.
Finally, the combination of the subsidy and existence of only two
secondary mortgage market GSEs conveys a duopoly to Fannie and Freddie
in the securitization of conforming, conventional one- to four-family
mortgages. The preponderance of evidence suggests that Fannie and Freddie
tacitly collude in this market (Goodman and Passmore, 1992; Hermalin and
Jaffee, 1996). The lack of a competitive market allows Fannie and Freddie to
retain more of the subsidy than they would be able to if the government
granted GSE status to a large number of non-colluding, secondary market
firms.
ESTIMATING FANNIE’s AND FREDDIE’s SUBSIDY
The General Accounting Office (GAO) made the first estimate of some
aspects of the direct subsidy that Fannie and Freddie receive. GAO arrived at
a value of $400 million for 1995. Much more attention has been paid to the
worth of the implicit subsidy. Analysts use four valuation techniques to
estimate the value of the implicit subsidy. First, some economists have
valued the implied guarantee as the difference between the market value of a
GSE and the market value of its assets and liabilities. Second, analysts have
treated the implied guarantee as creating an option to the GSEs to put their
assets to the federal government when the value of the assets fall below the
value of the liabilities backed by implied guarantee. The option is then
assessed using variations on market pricing techniques. Third, analysts have
calculated the implied subsidy as being equal to the difference between Fannie
and Freddie’s cost of funds with GSE status and without it. Finally, a
method that provides an indirect and incomplete valuation of the implicit
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subsidy involves determining how Fannie and Freddie’s activities have
lowered rates on conforming mortgages.
These techniques produced a wide range of subsidy estimates. Some of
the estimates are not directly comparable because they review different
component parts of the total subsidy for different years. The most recent
estimates of the total value of the subsidy for both firms put it at about $6
billion although estimates have been significantly lower in the past.
All four of these techniques have serious flaws and the estimates they
produce should not be taken too seriously as point valuations. Rather, they
are better understood as order of magnitude estimates and indications that the
subsidy could, at times, be extremely large. The estimates also demonstrate
that the enterprises have much more control over the subsidy than does the
federal government. More importantly, they provide evidence that the federal
government has little idea about the amount of resources it provides Fannie
and Freddie at the time the resources are provided.
Estimating Explicit Subsidies
Estimates of the three explicit subsidies, exemption from state and local
income tax, exemption from SEC registration, and free provision of a
Treasury back-up letter of credit, are rare with only one, by GAO, available
(General Accounting Office, 1996a)
SEC Registration Fee. The Congress sets the SEC fee for registration in
legislation. In 1995, for example, the fee was .034 percent (or 3.4 basis
points) of the face value of the security being issued. GAO estimated the
savings of the exemption to Fannie and Freddie by multiplying the fee by the
total face value of their debt issuance. GAO found this savings to be about
$102 million in 1995. Even this simple estimate requires some assumptions.
GAO excluded short-term debt from the calculation as ASEC officials told
[GAO] that such debt could be defined as commercial paper and not be
subject to SEC registration fees (emphasis added)” (General Accounting
Office, 1996a: 5).
State and Local Income Tax. Corporations such as Fannie Mae and Freddie
Mac with regional operations and nationwide activities are taxed by a number
of states. It is not clear, a priori, which states would tax Fannie and Freddie
and how such a levy would be calculated by each state (Zimmerman, 1995).
As a result, GAO used an estimated average state income tax and found that
the state component of the exemption would be worth about $367 million.
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GAO did not estimate the local government portion of the exemption. If
possible, Fannie and Freddie would modify their legal structure and negotiate
with their main state and local taxing authorities to reduce their tax payment
once the exemption was lifted. Thus, Fannie and Freddie would not likely
pay the full amount of the taxes that GAO (1996a) calculated.
LOC and Credit Rating. GAO understated the worth of Fannie and Fannie’s
direct benefits by not including an estimate of the value of the back-up LOC
from the U.S. Treasury. Likewise analysts have not estimated the savings
that Fannie and Freddie receive because they do not have to obtain credit
ratings on their debt.
Estimating Implicit Subsidies
Analysts have used three general methods for estimating the value of the
implicit guarantee: A market value accounting approach, a related option
pricing approach, and a debt or capital comparison approach. Part of the
subsidy could also be examined by determining the reduction in mortgage
rates for loans financed by Freddie or Fannie. Table 1 summarizes the
research findings.
Market Value Accounting Technique. Kane and Foster (1986) provided the
first estimate of the value of Fannie Mae’s implicit subsidy by modeling the
income generated by the implicit guarantee as a capitalized, unbookable asset
that would, by first accounting principles, equal the difference between the
market value of Fannie as measured by its stock price and the net market
value of Fannie’s assets (Kane and Foster, 1986). More specifically, they
view the implicit guarantee as creating an income stream or premium for
Fannie Mae each year. The premium represents the rate differential between
Fannie’s cost of funds without the guarantee, what Kane and Foster (1986)
called the warranted rate, and their cost of funds with the implicit guarantee.
They argued that the capitalized value of the income premium minus the
capitalized fees for the implicit guarantee, which they put at zero, is a capital
asset that belongs on the asset side of Fannie Mae’s balance sheet.
Kane and Foster (1986) marked Fannie’s assets and liabilities, almost
entirely mortgage loans and borrowings respectively, to market as of the end
of each year for the period 1978 to 1985. They also determined the market
value of the firm for the same period based on outstanding shares and stock
prices. The value of the implicit guarantee is then derived based on what
Kane and Foster term, “the first principles of corporate finance.” Namely,
the market value of Fannie Mae must equal the market value of its bookable
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and unbookable assets (e.g., the capitalized value of the income premium
from the implicit guarantee) less its bookable and unbookable liabilities (e.g.,
the capitalized fees of guarantees). In other words, the net value of the
implicit guarantee will equal the market value of the firm minus the net value
of marked-to-market booked items. They found that the value of the
guarantee ranged from $600 million to $11 billion in the 1978 to 1985 period.
The Congressional Budget Office (CBO) updated Kane and Foster
(1986). CBO (1996) divided the annual cost to the government of providing
the unbooked asset into two components. One component is the annual
change in the value of the asset that the government provides to Fannie and
Freddie. Of course, Fannie and Freddie will have more equity in periods
where the unbooked asset is worth more. As such, CBO characterized the
subsidy as the provision of equity to the GSEs. The second component tries
to capture the value of the equity that the unbooked asset provided in earlier
periods. This value was described as the return that taxpayers have foregone
on equity provided in earlier periods. To measure the foregone return on
equity, taxpayers were assumed to earn the same return as other equity
holders. CBO found that the cost to the taxpayer of providing the implicit
support to Fannie and Freddie averaged $7.8 billion for the period 1993 to
1995.
Weaknesses of Market Value Technique. There are at least three serious
concerns with the market value approach of Kane and Foster (1986).(7) First,
they assumed that the only unbooked assets and liabilities of value for Fannie
Mae relate to the implicit guarantee. However, Fannie and Freddie could
benefit from unrecognized “goodwill” reflecting the value of their experience
and relationships in the secondary mortgage market. The market value of
thousands of publicly traded firms exceeds their book value in part because of
such unbooked assets. Some of these non-GSE firms would also have
market values exceeding their book values after the latter is adjusted to reflect
market prices. Second, Kane and Foster (1986) could have underestimated
the indirect costs of receiving the implicit guarantee such as regulation and
restrictions on business opportunities. Finally, analysts may not correctly
mark the GSEs’ assets to market. This problem would appear to be
somewhat obviated because both Fannie Mae and Freddie Mac have
disclosed their mark to market values since 1992. But, these estimates will
become less reliable as the portfolios of both firms contain more complicated
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mortgages and securities, and as Fannie and Freddie have increasing
incentives to manipulate their valuation to make the implicit subsidy appear
small.
Option Pricing Technique. There is a substantial literature of modeling and
valuing federal deposit insurance (FDI) as a put option.(8) Under this
approach, the deposit insurance guarantee is treated as if it were a European
put option.(9) The examination schedule, or audit period, of the institution
determines the maturity of the FDI option. The exercise price of the FDI
option is captured in the value of its insured deposits. If the net of the bank’s
assets and uninsured liabilities is less than this strike price, the bank is
insolvent, the option is exercised and owners of the bank put its assets to the
federal insurer who must bear the difference between net assets and insured
liabilities. GSEs are provided with a conceptually identical put, although the
guarantee that creates the option is implicit. This description suggests that the
option approach is broadly similar to the Kane and Foster (1986) technique
described above. Both methods view the implicit guarantee as creating an
unbooked asset on the balance sheet of the GSE.
The difference between the two methodologies arises in the valuation of
the unbooked asset. Whereas Kane and Foster (1986) “back out” the value
of the unbooked asset, analysts using the option approach try to directly value
the put through the Black-Scholes framework.(10) Under a Black-Scholes
approach the value of the put option to the GSE depends on the value of the
firm’s assets, the value of the firm’s insured liabilities, the maturity of the put,
the volatility of the GSE’s assets, and the level of interest rates. Increases in
volatility of a firm’s assets or a decrease in the value of assets, for example,
would increase the value of the put option.
Schwartz and Van Order (1988) used a variant of the option approach
to explore the value of the implied subsidy. However, because they believed
the conditions under which the GSE would be closed and the option exercised
were not clear, they solved the option equation for the maturity of the put and
the riskiness of the firm’s assets where the value of the put was given by
Kane and Foster (1986). By examining the riskiness of the GSE’s assets and
the audit period, they were able to explore the degree to which Fannie fully
exploited its subsidy. The more volatile the firm’s assets and the longer the
audit period the more Fannie exploits its guarantee. A longer audit period
suggests that Fannie can maintain a risky portfolio for an extended period
without adjustments. Using this test, Schwartz and Van Order (1988) found
that the subsidy was being exploited only partially during the period 1978 to
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1985.(11) The audit period was longest and the volatility of assets greatest
during the periods when Fannie’s financial strength was weakest. Martin and
Pozdena (1991) extended the same analysis for the period 1986 to 1990 and
found that Fannie exploited the subsidy partially even during an economic
climate conducive to very high profits.
Both Cook and Spellman (1992) and Gatti and Spahr (1997) used a
variant of the option pricing model to value the implicit guarantee. Cook and
Spellman (1992) noted that GSEs pay a premium over the Treasury to
borrow because investors have doubts about whether the government would
bail them out. Cook and Spellman (1992) wanted to determine how this
bailout premium affects taxpayer exposure to GSE losses. To do that, Cook
and Spellman used the option pricing framework to determine how much the
government should charge to provide the option to the GSE. This charge
reflects the expected losses the government would suffer on the option and
equals the GSE subsidy, and taxpayer exposure, as the option is provided to
GSEs at no charge. This calculation allowed Cook and Spellman (1992) to
determine how changes in the bailout premium affect taxpayer exposure.
Cook (1996) and Spellman (1992) made a number of simplifying
assumptions in order to provide values necessary to calculate the option value
in the Black-Scholes framework. For example, as benchmarks for GSE asset
variance they used the volatility of short-term Treasury securities and the
variance of bank assets. Other parameters were also obtained via previous
bank and thrift research. They found that the value of the option, and hence
the value of the subsidy, depends a great deal on the capitalization of the GSE
and the bailout premium charged by the market. If the bailout premium was
100 basis points and the GSE’s capital to asset ratio was 3 percent, the option
would be worth 33 basis points. A bailout premium of 50 basis points and 2
percent capitalization would yield a 47 basis point subsidy. Although the
authors did not make a point estimate of the implied guarantee, Cook and
others suggested that their lower estimates (e.g., below 20 basis points) were
most relevant (Cook, 1996; Shilling, 1996). In general, they found that
higher bailout premiums increased the subsidy by making it more likely that
the GSE would falter due to its higher borrowing costs.
Gatti and Spahr (1997) used the same general technique to value the
implicit guarantee on Freddie Mac MBS. (12) Since the Schwartz and Van
Order (1988) analysis, the Congress mandated an annual safety and
soundness inspection. This allowed Gatti and Spahr to set the maturity of the
GSE put at one year. Gatti and Spahr also faced the difficulty of trying to
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determine the volatility of the underlying assets of the put, in this case the
mortgages supporting Freddie’s MBS. They addressed this concern by
developing an actuarial model to estimate the expected losses that the
government would face by implicitly insuring Freddie Mac’s MBS. The
expected losses were the basis for determining the premium that a firm that
cannot absorb losses from its own resources would pay to be insured by a
risk neutral insurer that has no default risk. Gatti and Spahr used this
premium as a proxy for the value of the put option and backed out an
estimate for the variance of the underlying assets of Freddie Mac’s MBS
through the Black-Scholes methodology. This figure was then used, in
conjunction with the actual financial condition of Freddie Mac, to determine a
recent value of the GSE put option for MBS. Gatti and Spahr took into
account the capital level, loan loss reserves and cash flows of Freddie Mac to
ensure they were only valuing the implicit guarantee of the federal
government and not the value of the guarantee provided by Freddie Mac
based on its own financial resources and/or the MBS collateral. They found
that the most likely value for the implied guarantee in 1993 for Freddie Mac
was 8.3 basis points, or about $410 million.
Techniques Demonstrate GSE Subsidy Control. Both the option pricing
and mark to market methods demonstrate that Fannie and Freddie, and not
the providers of the subsidy, control the value of the subsidy they receive.
The more risk the GSEs incur, the higher the value of the unbooked asset and
the greater the subsidy.
Weakness of Option Technique. The fact that a GSE controls the value of
the put also suggests that it is not really like other puts and that this valuation
method may have conceptual drawbacks. The Black-Scholes framework was
designed for options where the holder cannot affect the value of the option.
Yet, the holder of the GSE put controls its value. Practically, this means that
the volatility of the assets of the GSE can change substantially in a very short
period. This is problematic in option calculations because small errors in the
estimation of volatility can have major effects on the value of the option
(Blair and Fissel, 1991). Another concern with the option pricing approach is
uncertainty about if, or when, the government would take over GSEs and
make good on their debts. As Cook and Spellman demonstrated, the value of
the option is very sensitive to the market’s perception of government closure
policy. These types of problems mean that specific dollar estimates of the
GSE subsidy estimates obtained via an option pricing model are extremely
suspect. (13)
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Debt and Capital Comparison Technique. A Congressional objective in
providing Fannie and Freddie with an implied guarantee was to lower their
costs of raising funds. Analysts have tried to directly estimate the value of
the guarantee to the enterprises by determining how much of a cost of funds
advantage GSE status provides them.
Thygerson (1990) estimated the value of the implicit subsidy of Fannie
and Freddie through a two-part comparison. First, Thygerson (1990)
compared Fannie’s and Freddie’s borrowing costs to insured depositories’
borrowing costs. He stated that Fannie and Freddie borrow at rates about 20
to 35 basis points above comparable U.S. Treasuries. He then found the
spread between a variety of one year bank CD rates and comparable
Treasury securities and estimated that the agency cost of funds advantage
was 30 to 80 basis points over insured depositories. Second, using a very
simplified equation for the break-even rate of investing in conforming
mortgages, he found that Fannie and Freddie could undercut depositories by
40 to 74 basis points on a given mortgage investment. He attributed the
advantage exclusively to the lower capital requirements of Fannie and
Freddie. Thygerson (1990) combined these figures to conclude that the
implicit guarantee provides at least a value of 70 to 154 basis points in the
cost of raising funds.
Hemel (1994) compared GSE MBS versus top-rated MBS issued by
private conduits, private organizations without implicit government support
that assemble mortgages in large pools and issue securities backed by the cash
flows of the pooled mortgages. He found that top rated private MBS trade at
yields about 30 to 40 basis points above comparable Fannie and Freddie
MBS. He argued that the guarantee fee charged by Fannie and Freddie on
their MBS (about 20 to 25 basis points) was roughly equal to the credit
enhancement and administrative costs that private conduits bear. As such, the
30 to 40 basis point advantage is approximately what Fannie and Freddie gain
in the MBS market by being GSEs.
Ambrose and Warga (1996) also compared GSE bonds to non-GSE
corporate debt by pairing the bonds by factors including liquidity, callability,
taxability and maturity. The non-GSE debt was grouped according to bond
ratings and the types of firms issuing the debt. GSE debt was compared to
finance industry debt, all corporate debt, and the debt of General Electric.
Because they hold a variety of important bond structure features constant,
Ambrose and Warga (1996) assumed that the spread between similar GSE
and non-GSE debt resulted from GSE status. The value of the implicit
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guarantee then depends on Fannie and Freddie’s true credit quality. Ambrose
and Warga found that if the GSEs were rated ‘AA’ without GSE status, they
would pay 100 basis points more to issue debt. A rating of ‘A’ would lead to
a 200 basis point increase. These estimates put the after-tax value of the
implicit subsidy for debt at between $1.4 billion and $2.75 billion for Fannie
Mae and $330 million and $660 million for Freddie Mac in 1993. They did
not provide an estimate of the value of the implied guarantee for the agencies’
MBS.
Ambrose and Warga (1996) also tried to determine the value of the
subsidy in 1993 by determining how much Fannie and Freddie’s weighted
average cost of capital (WACC) would have increased if they lost their GSE
status. The WACC measure captures both the cost of borrowing and equity.
Ambrose and Warga compared the WACCs of Fannie and Freddie to that of
a sample of banking and finance firms. They found that Fannie Mae’s
WACC was significantly higher than that of the non-GSE sample even though
the riskiness of an investment in Fannie Mae was significantly lower.
Ambrose and Warga estimated a new WACC for Fannie by adjusting the
riskiness of Fannie to reflect that of the banking and finance firms it would
likely resemble if it lost its implied guarantee. That is, how much more of a
return will investors demand from Fannie if the firm did not have an implied
guarantee. They found that if Fannie received an ‘A’ rating without its
government support, its cost of capital would have increased about $3.6
billion per year (this does not capture GSE benefits for MBS issuance). This
increase almost entirely (90 percent) reflected increased costs of borrowing.
The subsidy estimates generated through the WACC and debt comparison
methods were similar.
CBO (1996) also relied on a comparative method to generate values for
the implicit subsidy. CBO argued that the savings in debt costs that GSEs
reap represent the value of the subsidy because the GSE would pay, at a
minimum, a sum equal to the cost savings in order to acquire the implicit
guarantee. In order to determine the savings on debt, CBO assumed that
Fannie and Freddie would have had a credit rating of ‘Aa’ without GSE status
and that the amount and type of debt they would have issued would not
change with the lower credit rating. Based on Ambrose and Warga’s (1996)
methodology, CBO (1996) compared yields on GSE debt with yields on debt
issued by ‘Aa’ rated financial firms to determine the savings on debt
produced by GSE status. CBO relied on existing estimates of the reduction in
MBS yields produced by GSE status when making their own estimate of the
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MBS subsidy. Previous estimates of the spread between GSE and non-GSE
MBS were between 25 to 60 basis points. CBO used 40 basis points to
determine the savings that Fannie and Freddie receive on their MBS. Based
on this assumption, the savings on debt and MBS for both GSEs in 1995
under the comparative approach was about $6.5 billion.
The U.S. Treasury (1996) followed the same logic as CBO arguing that
the value of the implicit guarantee for MBS equals the reduction in borrowing
costs that the GSE status produces. The U. S. Treasury (1996) took the 25
to 60 basis point advantage developed by CBO and chose a 35 basis point
estimate based on information provided by market participants. To estimate
the savings in debt issuance, it compared the yield on debt issued by financial
firms with large portfolios of residential mortgages and high credit quality
(usually rated ‘A’) with the yields on Fannie and Freddie debt. The yield data
were provided by Bloomberg Financial Services and were designed to
compare bonds with different structures on an equal basis (e.g., embedded
options are priced for each bond to facilitate comparisons). The U. S.
Treasury (1996) found a spread of about 55 basis points between medium
and long-term GSE and non-GSE debt and 18 basis points for short term
debt. Finally, the U. S. Treasury added in the GAO estimates of direct cost
savings that Fannie and Freddie receive. Based on the GSEs’ 1995 balance
sheets, it estimated the Fannie and Freddie subsidy at $5.8 billion with a
range of $5 to $6.5 billion.
Weaknesses of the Comparative Technique. The comparison method of
subsidy valuation also has serious limitations. The primary drawback is that
GSE MBS and debt are inherently different than debt and MBS issued by
non-GSE firms.
For example, private conduits make use of a
senior/subordinated structure for their MBS that the GSE can avoid because
of the implied guarantee. Likewise, no other firms but GSEs can issue as
much callable debt as Fannie and Freddie. These structural differences make
it very difficult to compare similar securities. The small number of similar
pairs means that the estimates of spreads between GSE and non-GSE
securities will have a significant variance. The comparisons, as the U. S.
Treasury (1996: 32) noted in terms of its valuation of the spread on long-term
debt, “ ‘provide, at best, a rough estimate of the magnitude of the GSEs’
advantage’. Data for more careful comparison are not easily found.”
Likewise, Shilling (1996) found the WACC calculations of Ambrose and
Warga (1996) to be unreliable arguing that Fannie and Freddie were not really
like firms to which they were being compared. Ambrose and Warga (1996)
ESTIMATING AND MANAGING THE FEDERAL SUBSIDY OF FANNIE MAE AND FREDDIE MAC
99
were especially concerned about the aggregate comparisons between GSE
and non-GSE MBS. Collateral varies from one MBS to another in terms of
geographic distribution, use of private mortgage insurance, and seasoning. As
such, an analyst could incorrectly attribute the reduction in yield to GSE
status when the spread represents collateral differences between MBS.
Even if the GSE and non-GSE securities were more similar, the
comparative method requires analysts to guess as to the credit rating that
Fannie and Freddie would have without agency status. This reduces the
comparative method to providing wide ranges of subsidy estimates unless the
rating agencies regularly issued ratings for Fannie and Freddie’s debt that did
not take GSE status into account.
Finally, these estimates provide significantly different values over time.
Indeed, in some periods the comparison estimates show no subsidy at all
(Shilling, 1996). This concern about consistency across time can be raised
with the other subsidy methods as well. CBO notes that its estimates from
the comparative method were “roughly consistent” with its estimates from the
mark to market method. The two methods produce similar results, however,
only when averaged over a three year period (1993-1995). CBO’s estimates
using the mark to market and comparative methods for any given year were
widely dissimilar. In 1995, the difference in the valuations produced by the
two methods was about $14 billion (Congressional Budget Office, 1996:
Tables 5 and 6). Finally, concerns about model specification used in the
comparative method have been raised (Cook, 1996).
Reduction in Mortgage Costs. Hendershott and Shilling (1989), ICF
Incorporated (1990), and Cotterman and Pearce (1996) estimated the
difference between rates on mortgage loans above the conforming limit and
rates on loans below the conforming limit. All three studies used a similar
regression approach in which they hold important factors affecting mortgage
rates constant so that the effect of conforming status is isolated. All three
studies found that, all else equal, a conforming mortgage is about 30 basis
points cheaper than a mortgage above the conforming limit. (14) Attributing
this difference solely to Fannie’s and Freddie’s GSE status would provide a
minimum estimate of the value of the implied guarantee. This figure is a
minimum because Fannie and Freddie are very unlikely to pass on the entire
subsidy to home buyers. As noted, the two firms are not subject to full
competition in their securitization markets. At the same time, the firms have
a duty to maximize shareholder wealth. This combination almost surely leads
both firms to retain part of their subsidy.
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The Benefit of Subsidy Estimates
The three estimation techniques have serious drawbacks if they are
interpreted as point estimates. The estimates provide more benefits when
viewed as the potential order of magnitude of the subsidy. The estimates
suggest that the combined subsidy could be in the billions of dollars for
Fannie and Freddie although in some years the subsidy could be much
smaller. Recognizing that the subsidy estimates are not exact does not imply
that they are too high. Indeed, none of these estimates tries to measure the
benefit of continual market access that GSE status provides Fannie and
Freddie.
The estimates produce the most benefits when viewed as models of the
basic relationship between GSE activity and the use of public resources.
What are the most important lessons policy makers can learn from these
models? First, the GSEs, not the federal government, control the size of the
subsidy. No matter the valuation method, the size of the subsidy increases
when the risk of the assets held or securitized by the GSE increases. The
GSE determines the risk of these assets. Estimates using the comparative
method, for example, demonstrate that the subsidy is greater for GSE
portfolio lending than it is for securitization. Thus, the GSE can increase its
consumption of public resources by issuing fixed-term debt in place of MBS.
Second, in some years it is questionable whether the GSEs are passing
the full subsidy on to home buyers given estimates of the subsidy and
estimates of the reduction in mortgage costs caused by the GSEs. The gap
between mortgage reduction and total subsidy is consistent with the fact that
two firms with GSE status dominate the secondary mortgage market and that
both firms are private corporations owned by shareholders. A recent model
of Fannie and Freddie’s mortgage purchases also suggests that little or no
subsidy may be passed on to home borrowers if the firms expend these
resources in the process of ensuring that they do not purchase low quality
mortgages (Passmore and Sparks, 1995).
Finally, and most importantly, the models reveal that the federal
government will never have a firm grasp on the amount of public resources
consumed by Fannie or Freddie at the time the resources are provided. On
the most basic level, policy makers do not have access to any accounting
records that document the cash flows of the subsidy. Estimates are required
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101
in the first place because the subsidies are off-budget, indirect or implicit.
Even if these estimation techniques produced accurate results, the findings
would still reflect after-the-fact valuations. Of course, the point at which the
federal government transfers public resources to Fannie and Freddie is the
only time at which the consumption can be controlled. Furthermore, the
difficulty with valuing the subsidy arises directly from the circuitous method
by which it is conveyed. Yet, indirect, off-budget subsidy transfers define
GSEs and are the very purpose for their creation. Thus, analysts have no
choice but to rely on uncertain estimating techniques that, in turn, require
comparisons or analogies that are inherently difficult to make. It is by human
design rather than bad luck or requirement of nature that the GSE put is not
really like puts traded on exchanges, GSE debt and GSE MBS are not really
like debt and MBS issued by private firms, and the GSE implied asset cannot
be isolated from other unbooked assets and liabilities.
It is not necessary to rely on third parties to come to the conclusion that
the federal government is ignorant of and does not control the resources it
provides Fannie Mae and Freddie Mac. Fannie Mae testified to the Congress
that the process of trying to estimate their subsidy is a “highly theoretical and
subjective” exercise because of the implicit, indirect manner in which the
subsidy is provided (Zoellick, 1996). Freddie Mac (1996a) also found that
methods of estimating the subsidy were too inaccurate to be relied upon.(16)
CAN THE FEDERAL GOVERNMENT EFFECTIVELY
MANAGE FANNIE AND FREDDIE’s SUBSIDY?
Analysts have offered a variety of plans for the federal government to
gain greater control over the amount of the subsidy that Fannie and Freddie
receive.(17) These proposals include reporting estimates of the current subsidy
in the federal budget and perhaps counting them as federal outlays, levying
user fees, requiring Fannie and Freddie to maintain a high credit rating absent
their implicit guarantee, further restricting the types of mortgages they can
finance or increasing their social investment requirements. The Congress has
already mandated risk-based capital requirements in order to better control
Fannie and Freddie’s risk taking. All of these proposals face very significant
challenges. First, the GSEs are much better informed about their risk-taking
than third parties. This information asymmetry reduces the ability of any
third party to effectively limit Fannie and Freddie’s risk exposure and subsidy.
Second, political incentives favor a maintenance of the current, uncontrolled
GSE subsidy. It also appears administratively inefficient for the Congress to
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simultaneously provide GSEs with benefits only to devise methods to reduce
the size of or redirect those benefits. These concerns among others has led
some analysts to call for removal of federal support for Fannie and Freddie.
Methods of Managing the GSE Subsidy
The following methods could limit the ability of the GSEs to control the
amount of subsidy they consume:
Include Subsidy Estimates in the Federal Budget. This proposal would do
nothing to directly control the size of the subsidy. But, the Congress may
“feel pressure” to gain control over the subsidy if it is reported in the federal
budget. The Congress will have greater incentive to exercise control if
subsidy estimates count as outlays that increase the budget deficit. One
method of achieving this budget outcome is to extend the Credit Reform Act
of 1990 to include Fannie and Freddie’s implied subsidy (Kane, 1996).
Levying User Fees. CBO (1997) and Miles (1995) suggest controlling the
subsidy of Fannie and Freddie by levying a fee on their use of public
credit. (18) The fee could be set equal to the estimated value of the implied
guarantee or some portion of this estimate. Fannie and Freddie have a more
limited incentive to use public credit without restraint when there is a charge
on its use. While some policy makers called user fees a tax increase on home
owners, it is actually a tax reduction for federal taxpayers whose credit is
currently expropriated.(19)
Mandated Credit Rating. The degree to which Fannie and Freddie could
exploit the federal implied guarantee would be limited if they were required to
maintain a ‘AAA’ rating without the credit rating firm considering their GSE
status. The Office of Federal Housing Enterprise Oversight (OFHEO) (1997)
is Fannie and Freddie’s safety and soundness regulator and contracted with
Standard and Poors to provide such a credit rating in 1997. Some subsidy
would still exist after this proposal was implemented as both firms currently
borrow at super-AAA’ rates. (20) Furthermore, credit ratings are known to lag
behind the financial condition of the rated firm’s and market’s assessment of
risk (CBO, 1991).
Limiting Financing Opportunities. Another method for limiting the ability
of Fannie and Freddie to exploit the subsidy would be to further restrict the
mortgages that they can finance. The conforming limit could be lowered, the
total amount of MBS outstanding and mortgages in portfolio could be capped
and/or the credit quality of mortgages they finance could be increased in order
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to achieve this goal. The fewer mortgages they finance, the lower their
subsidy all other things equal. Of course, “other things” are never equal and
if Fannie and Freddie are prevented from taking risk in one aspect of their
business, they will be able to exploit risk-taking opportunities in other areas.
Capital Requirements. Legislation in 1992, the Federal Housing Enterprise
Financial Safety and Soundness Act, established two new capital
requirements for Fannie and Freddie. First, they must meet a minimum
capital standard equal to the sum of 2.5 percent of aggregate on-balance-sheet
assets, 0.45 percent of the unpaid principal balance of outstanding MBS and
substantially equivalent instruments, and 0.45 percent of other off-balancesheet obligations. Both firms have met this standard each year since its
inception. Second, both firms must meet a risk-based capital standard that
has not yet been finalized. The standard will require that both firms maintain
enough capital to withstand a severe interest rate shock together with adverse
credit conditions over a 10-year period plus an additional 30 percent of that
amount to cover management and operations risk.
Increase Social Investment. Fannie Mae and Freddie Mac must meet three
housing goals as promulgated by the Department of Housing and Urban
Development. A certain percentage of the mortgages purchased by Fannie
and Freddie must finance housing (1) for low- and moderate-income families,
(2) located in areas considered to be geographically underserved, and (3) that
meets the needs of very-low income families and low-income families living
in low-income areas (Retsinas, 1996). Congress could increase the exisiting
targets and/or create new, more focused goals to reduce the subsidy that
Fannie and Freddie retain and better target the subsidy to specific households
or firms. These reforms would not provide policy makers with a better grasp
of the size of the subsidy but would offer them a crude to tool to manage it.
Systemic Challenges of Managing the Subsidy of Fannie Mae and
Freddie Mac
The options above would provide tools for the federal government to
control the size of the subsidy that Fannie and Freddie receive if implemented
with perfect information and operational skill. But, there are two hurdles that
make anything approaching perfection an unachievable goal. First, the
options require that a third party know the true risk profile of both firms on
almost a continuous basis. Such a state is impossible to achieve with resource
constraints. Second, Fannie Mae and Freddie Mac have extremely strong
incentives to use their political clout to prevent the options from being
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implemented effectively. Policy-makers should be receptive to Fannie and
Freddie’s needs as the current subsidy structure increases their own welfare.
Finally, these tools often appear administratively inefficient; why choose to
provide housing subsidies through indirect, untargeted means only to
implement tools to reduce the level of subsidizaton or make the subsidy more
direct?
Information Asymmetry. Several of the options of managing a subsidy
discussed above require a third party to be able to accurately assess the level
of the subsidy that Fannie and Freddie enjoy or accurately measure the risks
that they bear many times a year. But, as discussed above, it is extremely
difficult to assess either of these on an irregular basis. Moreover, whatever
tool the federal government uses to manage the GSE subsidy will have to be
fairly general to be practical. The federal government would face significant
problems, for example, in implementing an extremely detailed system of fees
based on a large number of variables. Such a system requires the agency
assessing the fee to collect extremely detailed, virtually unverifiable,
information on the regulated entity. The calculations would also require
assumptions that cannot be made with confidence. The more complicated
the fee setting process, the more likely the regulated institution could
challenge the rate derived by the regulator. In addition, a fee based on very
specific factors would become outdated as new variables take on increased
importance in determining GSE risk. This would require the regulator to have
the flexibility to change the tool quickly. But, the Congress and courts have
developed a regulatory process to ensure public input, due process and
deliberation rather than to minimize response time.
The difficulties facing a detailed subsidy management program mean
that regulators would likely implement a general protocol. But, a broad rule
for measuring risk guarantees that risk will not be measured accurately. As
such, the GSE should be able to alter its risk position without facing
regulatory penalties (a higher fee, for example). The inability to accurately
measure risk has traditionally plagued bank regulators and insurers. The
regulator is at a profound informational disadvantage relative to the regulated
party in recognizing and measuring risk. Moreover, the third party assessing
these risks will not posses the incentives that entities assessing risks in private
markets have to accurately make and update assessments.
One way around this problem is to set fees or capital at a rate that
cannot possibly be too low. This strategy, however, encourages the GSE to
either drop its federal charter (as was the case with Sallie Mae) or take on
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105
increased risk so that the overestimated charges eventually reflect or
underestimate reality.
Political Power. Fannie and Freddie obtained and maintain their subsidy via
the political process. They derive substantial benefits from it. Thus, they
have significant incentive to protect the subsidy from any governmental action
that could reduce it. In other words, the enterprises obtain extremely high
payoffs from being well organized politically, well informed and able to
respond to critiques of their activities with credible responses. And their
political instincts are highly regarded. The chairman of the House Banking
Committee, Rep. James Leach, noted that the enterprises have Washington
connections that “are much stronger than all 13,000 financial institutions in
the 50 states” (Calmes, 1996).
In contrast, the costs of the enterprises’ subsidy are small on a pertaxpayer basis. Individual taxpayers, who would have to expend resources to
become informed about the enterprises, have little incentive to engage in
political action to oppose the enterprises’ subsidies. Analysts have long
considered subsidies, such as those accruing to Fannie and Freddie, with
concentrated benefits and dispersed costs characteristic of our democracy and
very difficult to eliminate.(21)
The political power of the two agencies has been exercised on many
occasions against plans that would reduce their subsidy. With regards to their
new risk-based capital standards for example, “ the stress test was not
performed before the bill was passed. Instead, it was negotiated between the
Bush Administration and the GSEs and written into law by Congress without
analysis of how much capital will be required to meet it” (Weicher, 1994: 58).
Likewise, plans to levy a user fee were dismissed by market observers as
having little chance of passage because of the political power of Fannie and
Freddie (Kleinbard, 1996). Furthermore, Fannie and Freddie’s regulator is
currently dependent on the two firms for its funding. This arrangement
provides Fannie and Freddie with considerable political and financial leverage
over the regulator and increases the potential that Fannie and Freddie could
“capture” it.
Policy makers also have several reasons for maintaining the current
structure of indirect subsidies to Fannie and Freddie. First, the subsidies are
not recorded in the federal budget. Policy-makers can get credit with
constituents for Fannie and Freddie housing initiatives without having to give
up financial support for other federal programs. Second, the indirect and
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convoluted nature of the link between the GSEs and the federal government
gives policy-makers plausible deniability if either of them suffers financial
difficulties. (22) Third, Congresspersons can use the threat of subsidy
reduction to increase contributions and other benefits that the agencies can
directly bestow upon them. (23) Congress would not receive such pecuniary
benefits from a federal agency that received an equal subsidy. Finally, Fannie
and Freddie can brand those policy makers who try to eliminate their subsidy
as supporters of a tax increase.
Administrative Inefficiency. Some of the subsidy control tools described
above appear inefficient, from an administrative perspective, even if the
government could apply them perfectly. For example, “requiring the [GSE]
to compensate the government for [its] privileges simply undoes the benefit”
(Woodward, 1997: 4). Likewise setting housing targets such that the GSE
transfers all of its subsidy begs the question why the government does not
simplify its process and provide the subsidy directly to targeted beneficiaries.
More generally, the findings of this review indicate that weak control
and poor informational oversight are inherent in transmitting subsidies through
Fannie and Freddie. Thus, the point at which policy makers must devote
considerable resources to controlling GSEs’ use of their subsidy or making
their subsidy more explicit is the time when the rationale for using a GSE as a
conduit for subsidy transmission may have run its course. Indeed, the
inability to obtain precise information on the subsidy, control its use, and
ensure that its benefits flow to home buyers explains why some analysts favor
its elimination (issues surrounding the mechanics of “privatization” have also
been reviewed elsewhere (Stanton, 1996).
CONCLUSION
Fannie Mae and Freddie Mac receive direct and indirect benefits from
the federal government. A recent estimate of the direct benefits placed their
value at about $400 million. There are three primary methods for assessing
the amount of the indirect subsidies. None of these will yield accurate point
estimates for any given year. But, these estimates provide rough order of
magnitude estimates that suggest Fannie and Freddie could receive billions of
dollars in subsidies in some years and much smaller amounts in other years.
Assessing the size of the implied subsidies is most valuable in demonstrating
that Fannie and Freddie, not the federal government, control the size of the
subsidy and proving that the federal government does not know the level of
ESTIMATING AND MANAGING THE FEDERAL SUBSIDY OF FANNIE MAE AND FREDDIE MAC
107
resources it provides Fannie and Freddie at the time they consume the
resources.
There are several methods by which the federal government could try to
gain better control over the size of the subsidy that Fannie and Freddie
receive. However, the managers of these tools would have to overcome both
the massive information disadvantage that a third party faces in assessing
Fannie and Freddie’s risks and the political incentives that lead Fannie,
Freddie and the Congress to maintain the status quo. The effect of these
tools may also run counter to the rationale for creating Fannie and Freddie.
These drawbacks provide a strong rationale for examining the elimination of
the indirect subsidy.
NOTES
*
The views expressed in this article are the author’s and not necessarily
those of the Federal Reserve Bank of Minneapolis or of the Federal
Reserve System.
1. Section 1404 of the Financial Institutions Reform, Recovery and
Enforcement Act of 1989 required the General Accounting Office and the
U.S. Treasury to issue two studies on the risks posed by government
sponsored enterprises and the potential methods for managing these risks.
Section 135018 of the Omnibus Budget Reconciliation Act of 1990
required the Congressional Budget Office to analyze the financial risks
posed by the government sponsored enterprises and review risk
management strategies. See, for example, Congressional Budget Office
(1996), U.S. General Accounting Office (1996b), and U.S. Department
of Treasury (1996).
2. Section 1355 of the Federal Housing Enterprise Safety and Soundness
Act of 1992 directed the Secretary of the Treasury, the Secretary of
Housing and Urban Development, the Comptroller General and the
Director of the Congressional Budget Office to study the desirability and
feasibility of repealing the charters of Fannie and Freddie, eliminating
federal sponsorship of the enterprises, and permitting them to operate as
fully private entities.
3. More detailed discussions of Fannie Mae’s and Freddie Mac’s operations
are found in Congressional Budget Office (1991) and U.S. Department of
Treasury (1990).
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4. Section 1381 of the Federal Housing Enterprise Safety and Soundness
Act of 1992 amended Section 301 of the Federal National Mortgage
Association Charter Act in order to update the firms’ charters. Kaufman
(1988) found that Fannie Mae did not provide countercyclical housing
credit.
5. Mortgages in portfolio include mortgage backed securities held in
portfolio.
6. On two occasions the Federal government has effectively bailed out a
government sponsored enterprise. In the late 1980s, the Congress bailed
out holders of Farm Credit debt and in 1996 the Congress ensured that
holders of FICO debt would receive full payment when such payment
was in doubt.
7. These concerns were also raised by Schwartz and Van Order (1988),
Congressional Budget Office (1996), and General Accounting Office
(1985).
8. Marcus and Shaked (1984), Merton (1977) and Ronn and Verma (1986)
are the seminal works of this literature.
9. An American option allows the holder to exercise their rights on or before
the expiration date while a European option allows exercise only on the
expiration date.
10. See Fortune (1996) for a discussion of this methodology.
11. Schwartz and Van Order (1988) offer three reasons why Fannie might
not exploit the subsidy fully by engaging in risky behavior. First, in some
models, excess risk-taking reduces the charter value of a monopolist.
Second, the employees of Fannie Mae may face costs from excess risktaking. Third, excess risk-taking may encourage regulatory sanction. In
addition, the Congress may seek to reduce the subsidy of Fannie Mae if it
appears that the firm is exploiting the federal subsidy too aggressively.
12. Gatti and Spahr (1997) note that almost 90 percent of all mortgages
financed by Freddie Mac in 1993 were securitized. Thus, their estimate
of the value of the guarantee for the mortgage backed securities is a
rough approximation of the value of the entire implied guarantee.
13. The literature review in Flood (1990) makes clear that option pricing
models do not generate accurate point estimates for the value of the
deposit insurance put. But, Flood finds that these models are useful for
ESTIMATING AND MANAGING THE FEDERAL SUBSIDY OF FANNIE MAE AND FREDDIE MAC
109
determining the relative riskiness of banks or for investigating how
changes in the structure of the government guarantee affects the value of
the federal subsidy conveyed through deposit insurance.
14. More precisely, Cotterman and Pearce (1996) found a spread of 15 and
60 basis points between mortgages below the conforming limit and
mortgages above the conforming limit. The lower estimates occurred in
more recent years. Cotterman and Pearce (1996) found that 25 to 40
basis points was the core range of the differential. ICF’s point estimate
was 23 basis points while Hendershott and Shilling’s (1989) was 30 basis
points.
15. See Fannie Mae (1996b) for more detailed comments on Ambrose and
Warga (1996).
16. Freddie Mac (1996b) argued that the subsidies it receive have “no cost to
taxpayers”. This statement can be true only if the benefits provided by
government sponsored enterprise status have no value. Yet, Freddie
goes on to argue that its government sponsored enterprise status allows it
to borrow at lower rates. Clearly, other firms would pay to receive this
benefit.
17. See Congressional Budget Office (1991; 1996), U. S. Treasury (1990;
1991), U. S. General Accounting Office (1985; 1990; 1991) for in-depth
reviews of many of these proposals.
18. Congressional Budget Office (1997) asserted that government sponsored
enterprise status reduces the enterprises’ long-term debt costs by about
70 basis points and their mortgage backed securities costs by about 35
basis points and determined that a user fee set at an arbitrary level of 20
basis points and charged against average debt outstanding would generate
$900 million a year in federal collections. Miles (1995) also discusses
user fees for Fannie and Freddie.
19. Speaker of the House Gingrich, for example, argued that user fees on
Fannie Mae and Freddie Mac were taxes (Kleinbard, 1996).
20. While it is standard to note that Fannie and Freddie have lower borrowing
rates than AAA rated firms, one reflection of the difficulty in making
subsidy estimates is found in Ambrose and Warga (1996) who found that
government sponsored enterprise borrowing rates would not change if
they obtained a AAA rating after losing the implied guarantee.
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21. Downs (1957) was one of the first analysts to identify this trend.
22. Fear that this veil might be pierced during a bailout would provide a
countervailing force.
23. The Chairman of the Senate Banking Committee raised his request for
political contributions from the two agencies at the same time the
Congress was going to hold hearings on reports that were critical of their
subsidy, see Prakash (1996).
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