paper about MBS

At the time that the study was announced fannie and

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Unformatted text preview: At the time that the study was announced, Fannie and Freddie went into attack mode and criticized the methodology and results. When one looks at the CBO’s assumptions, however, one could provide an argument the other way: the CBO underestimated the subsidy. The main assumption was that, without government support, Fannie and Freddie would have had the same amount of debt and off-balance sheet guarantees. But their leverage was extraordinary and almost certainly would have commanded a much lower credit rating. Further, no adjustment was made for the added systemic risk that was produced – the steady, unfettered rise of housing-related debt in the United States as part of national wealth – and retained by Fannie and Freddie. 25 In a May 2001 updated study, the CBO estimated that the annual implicit subsidy had risen to $13.6 billion by the year 2000. A few years later, Federal Reserve Board economist Wayne Passmore, using a similar methodology and a standard discounted earnings model over a forward-looking 25-year horizon, estimated that the aggregate value of the subsidy ranged somewhere between $119 billion and $164 billion, of which shareholders receive respectively between $50 and $97 billion. Astonishingly, the subsidy was almost equal to the market value of these two GSEs, providing further evidence against the desirability of their existence in their current form. 8 Year after year, a large number of economists and policy-makers questioned the distortions that were being created by this “big fat” subsidy. In what is perhaps one of the more eloquent summaries of subsidy-related distortions, a speech on May 19, 2005, by the then Federal Reserve Chairman Alan Greenspan explains the growth of GSE balance sheets and their guarantee-driven shareholder value: 9 “Although prospectuses for GSE debt are required by law to stipulate that such instruments are not backed by the full faith and credit of the U.S. government, investors worldwide have concluded that our government will not allow GSEs to default… Investors have provided Fannie and Freddie with a powerful vehicle for achieving profits that are virtually guaranteed through the rapid growth of their balance sheets, and the resultant scale has given them an advantage that their potential private-sector competitors cannot meet. As a result, their annual return on equity, which has often exceeded 30 percent, is far in excess of the average annual return of approximately 15 percent that has been earned by other large financial competitors holding substantially similar assets. Virtually none of the GSE excess return reflects higher yields on assets; it is almost wholly attributable to subsidized borrowing costs… The Federal Reserve Board has been unable to find any credible purpose for the huge balance sheets built by Fannie and Freddie other than the creation of profit through the exploitation of the market-granted subsidy.” 26 Chapter 2: Ticking Time Bomb “We didn’t really know what we were buying,” said Marc Gott, a former director in Fannie’s...
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At the time that the study was announced Fannie and Freddie...

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