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Because of the special status and treatment of the

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Unformatted text preview: Because of the special status and treatment of the GSEs that were described earlier in this chapter, the financial markets have historically treated them specially: The financial markets believed (correctly, as it turned out, or as a self-fulfilling prophesy) that if either company ever experienced financial difficulties, the federal government would likely intercede to make sure that the company’s creditors did not suffer any losses. This belief persisted despite the explicit statement on all GSE securities that these securities were not full-faith-and-credit obligations of the U.S. Government. The belief seems largely rational given that for most practical purposes, GSE debt is on par with Treasuries as “liquidity” or “risk-free securities” and therefore is held in hoards by financial firms much like Treasuries (in fact, 50% of GSE debt was held by financial firms in 2008). The “halo” effect of all of the special features of the GSEs was just too strong for them not to be deemed as too-big-to-fail. 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. the government to shareholders; that is, only two-thirds trickled down to the mortgage market....
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Because of the special status and treatment of the GSEs...

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