Revisiting the Net Benefits of Freddie Mac and Fannie Mae
Liquidity is lower for securities produced under the private-label process than under the GSEs’ guarantee because the latter process results in heterogeneous securities. In 2003 a report by staff at the Department of the Treasury, OFHEO, and the Securities and Exchange Commission found that “the mortgage loans in private-label MBS generally have more diverse collateral, credit risk, or other underwriting characteristics than GSE or Ginnie Mae MBS and have wider variances in a number of terms including interest rate, term, size, purpose and borrower characteristics.”23
All Freddie Mac and Fannie Mae mortgage- backed securities have basically the same minimal credit risk, even after some seasoning. Investors are indifferent between pools with varying experience as far as credit losses go, because the GSE guarantee equalizes the risk. As stated by the CBO in its 2003 report,
The GSEs’ MBS are highly liquid primarily because they are relatively homogeneous; the large size of the market also helps liquidity. Thus, investors determine value largely on the basis of generic characteristics such as coupon rate and maturity, rather than valuing each MBS issue on its own. Additional information that per- mits investors to differentiate among MBS on the basis of expected prepayment rates may fragment the market and thus reduce MBS’ liquidity and price.24
structure. Differences in payment histories affect the perceived risk of the senior security, and these differences create an incentive for investors to undertake research to differentiate among securities. This incentive prevents the pools using the senior/subordinate structure from ever reaching the levels of liquidity now found in GSE mortgage securities (and the liquidity for the B tranches is even lower).
Another reason that the private-label credit- enhancement process would not necessarily replicate the benefits of the GSE guarantee is that the market for the subordinated tranche of mortgage pools would have to expand by sev- eral orders of magnitude. We think it is unlikely that such an expansion could occur without an increase in the yields on these securities, and this increase would lead to higher mortgage rates in the primary market.25
Thus, we find ourselves in agreement with Richard Roll that:
It is impossible to overstate the importance of credit enhancement in the process of mortgage securitization ...Since mortgages have promised payments for up to 30 years, credit guarantees from the GSEs (and from GNMA, FHA, and VA) are very long-term commitments and hence are made more credible by the government’s association.26
The same is not true of securities that receive their AA/AAA rating through a senior/subordinate
U.S. Department of the Treasury, Office of Federal Housing Enterprise Oversight, and U.S. Securities and Exchange Commission, 2003. “Staff Report: Enhancing Disclosure in Mortgage-Backed Securities Markets”. Similar observations were made by former HUD Chief Economist Susan Woodward (2001) and by Green and Wachter (2005).
Woodward (2001) discusses the placement of the subordinate security in more detail.
Roll (2003), 29.
The Policy Debate Over GSE Activities