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Revisiting the Net Benefits of Freddie Mac and Fannie Mae

with MBS on the same scale and with the same liquidity as the current secondary market support- ed by the GSEs. This assumption is clearly the foundation for statements dismissing the potential benefits of the GSEs, as is evident in this excerpt from a letter by former Federal Reserve Chairman Alan Greenspan:

The FHLBs [Federal Home Loan Banks], Fannie Mae, and Freddie Mac were each chartered with the purpose of smoothing our regional imbalances in mortgage supply and integrating regional mortgage markets into the national capital markets. Much to their credit they succeeded in accomplishing this goal many years ago. Today, however, these organizations alter the housing finance markets only to the degree that they pass through to homebuyers part of their government subsidy.20

A similar point of view is expressed in a publica- tion of the Federal Reserve Bank of Atlanta:

At the time each housing GSE was created, the primary source of mortgage funding was local deposits; credit availability was thus closely linked to the local deposit market and general economic conditions. The housing GSEs improved the flow of credit to homebuyers by linking local and national credit markets. As financial markets have evolved, however, alternative mecha- nisms have arisen that enable retail lenders to tap national markets. Therefore, the major contribution of the housing GSEs is to transmit to homebuyers an interest rate subsidy that is made possible by the benefits the GSEs obtain from the federal government.21

The assertion that GSE securitization contributes nothing more than a subsidy is based on an as- sumption that mortgage securitization under fully private auspices would provide all the benefits of GSE securitization. To our knowledge, this

assumption has never been explained or defended. A comparison between MBS issued by Freddie Mac and Fannie Mae with private- label securities shows this assumption to be false. Not only would there be significant transi- tion problems, but also, as we show, the GSEs offer significantly enhanced securities compared with those of their private-label counterparts.

The Unique Benefits of GSE Securitization

The major difference between MBS issued by Freddie Mac and Fannie Mae and private-label securities is the nature of the credit enhancement. To be marketed successfully, a mortgage-backed security must have a credit rating of at least AA, a rating that pools of mortgages will not achieve without some form of enhancement. With their federal sponsorship, Freddie Mac and Fannie Mae enhance the credit of their securities by covering them with a guarantee. Non-GSE issuers, in contrast, usually obtain investment- grade ratings with a senior/subordinate structure—dividing the mortgage pool into at least two securities, with the credit risk con- centrated in a small, subordinate security that is assigned a below-investment-grade rating (the “B piece while the senior securities receive a AA or AAA rating”).22 This difference in credit- enhancement methods has important conse- quences. It is a qualitative difference that can have the broad scope of effects described by Penner and Silber (1973).

20

Greenspan (2000).

21

Frame and Wall (2002).

22

In the early years of jumbo securitization, credit enhancement from pool insurance and from other sources external to the pool itself was tried, but this method proved vulnerable to deterioration in the financial standing of the guarantor (Cotterman and Pearce 1996, 112). The GSEs’ special status makes this type of problem unlikely, partly because their charters restrict their activities to the secondary mortgage market and also eliminate the possibility that they would be involved in mergers or acquisitions.

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The Policy Debate Over GSE Activities

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