Fannie and Freddie’s Final Makeover

Arpit Gupta
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Though a dizzying array of legislative proposals envisioning wholesale reform have come and gone, these steady administrative reforms have resulted in stealthy but effective reform of the GSEs which have lowered their systemic risk and costs to taxpayers without materially affecting the performance of mortgage markets.
By Arpit Gupta
With the U.S. Treasury’s recently released plan to revamp Fannie Mae and Freddie Mac, an important piece of government-sponsored enterprise (GSE) reform is falling into place. Over a decade has passed since the 2008 subprime mortgage meltdown and the bailout of Fannie and Freddie, so you may be asking: What took so long? The answer is that the Treasury plan—developed with input from the Federal Housing Finance Agency and the Department of Housing and Urban Development—reflects the legacy of steady administrative reforms at the GSEs that have lowered the systemic risk of these institutions.

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.