24 with an implicit guarantee on their debt fannie

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24 With an implicit guarantee on their debt, Fannie and Freddie were able to borrow at interest rates that were below what the financial markets otherwise would have demanded. This meant that it was quite profitable for the GSEs to purchase mortgages and offer credit default guarantees below fundamental rates, allowing them to vanquish any competition and grow unfettered. Because fixed income investors – either those holding Fannie and Freddie debt or MBS guaranteed by Fannie and Freddie – believed that there was a government backstop, market discipline went out the window, and there was no one left to restrain Fannie and Freddie. As described in Section 1.4 above, adding to this subsidy was the fact that Fannie and Freddie had much lower capital requirements than did commercial banks and investment banks, for guaranteeing as well holding MBS. With such a lack of a level-playing field, there was really no free market. Instead of capital flowing to its most efficient use, as the deregulation of mortgage markets in 1980’s had anticipated, capital was in fact flowing to its most levered use. There was no one left to restrain Fannie and Freddie, of course other than the federal government, but in the pursuit of myopic goals of boosting home ownership at all costs, each successive presidential administration turned a blind eye. In a seminal study in 1996, the Congressional Budget Office (CBO) provided an estimate of the government subsidy for Fannie and Freddie in 1995. The two main factors that went into their analysis were (i) the reduced cost of financing compared to other highly rated financial institutions (e.g., 0.70% per year lower interest rate), and (ii) the lower cost of issuing MBS (e.g., 0.40%). Their estimated annual total subsidy was $6.9 billion, a very large number fifteen years ago. Moreover, the CBO argued that at least one-third was a complete transfer of wealth from the government to shareholders; that is, only two-thirds trickled down to the mortgage market. 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.
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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
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