Fannie and Freddie’s Final Makeover
— October 15, 2019
By Arpit Gupta
The Preferred Stock Purchase Agreement (PSPA) regulating the Treasury’s bailout of the GSEs called for a sharp reduction in the portfolio holdings of Fannie and Freddie. Though these GSEs are commonly known for their securitizing business, at their peak prior to the crisis they held an investment portfolio totaling 20% of the entire outstanding stock of mortgage-backed securities. These enormous holdings were largely the product of the GSEs leveraging their implicit bailout guarantee, and their resulting low cost of funding, in a form of regulatory arbitrage. The resulting subsidized and expansive portfolio helped to fuel the housing bubble, even if it was not the only factor, and added to substantial systemic risk in the financial system. Because of the PSPA, this portfolio has been wound down to a third of its formal level.
The introduction of credit-risk transfer (CRT) notes has additionally substantially de-risked Fannie and Freddie’s portfolio. These derivative structures are tied to Fannie and Freddie’s credit losses, and ensure that private companies bear much of the first loss in mortgage-backed securities, leaving Fannie and Freddie in the position of insuring only catastrophic losses, rather than other routine mortgage defaults. Through 2018, Fannie and Freddie have insured a total of $4 trillion in mortgage balances against credit risk through a variety of risk-transfer tools. The CRT program has been successful both in reducing taxpayer exposure to mortgage losses, as well as in establishing a market price of mortgage risk which can assist in other reform efforts going forward.
Read the full Economics21 article.
Arpit Gupta is Assistant Professor of Finance.