Vol. 8 No. 2 - Article II - Published: June 1995 - Full Article
Government-Sponsored Enterprises: Their Role as Conduits of Credit and as Competitors of Banking Institutions
by Panos Konstas
This paper examines the operations and growing importance of government-sponsored
enterprises (GSEs) in the financial system, and evaluates how these entities have affected the competitive landscape for banking institutions. GSEs are private entities fulfilling public purposes in housing, higher education, farming, and the thrift industry. The obligations of GSEs, which totaled about $1.6 trillion as of September 30, 1994, equaled 57 percent of the total deposits of commercial banks, up from 33 percent five years earlier.
The growth of GSEs has had important ramifications for the banking industry. As major
competitors on both the asset and liability sides of bank balance sheets, GSEs have contributed to a decrease in the interest margins available to banks. GSEs' competitive position has been enhanced by generally favorable rules concerning capitalization, income taxation, and the cost and scope of implicit federal guarantees of their obligations. At the same time, however, GSEs have been important contributors to the securitization of bank loans and the development of financial derivative instruments. These changes in financial technology have expanded significantly the business opportunities and strategies available to banks.
GSE's were created by the federal government to direct funds to particular sectors of the
economy that were believed to be served inadequately by the private credit markets. Although GSEs are authorized or established by the Congress, the Office of Management and Budget (OMB) excludes GSE data from the federal budget because they are officially classified as private entities.
As defined in this paper, the term GSE refers to a privately owned, federally chartered institution with nationwide scope and limited lending powers that benefits from an implicit federal guarantee on its borrowing of market funds. 1 There are currently seven GSEs that meet this definition. Three operate in the housing area: the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Banks (FHLBs), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Three GSEs operate in the farm credit area: the Farm Credit Banks (FCBs), the Banks for Cooperatives (BCs), and the Federal Agricultural Credit Corporation (Farmer Mac). One GSE facilitates student loans the Student Loan Marketing Association (Sallie Mae). 2
These GSEs were designed to ensure that adequate credit flows to farmers, home buyers, and college students. It has been argued that prior to the establishment of GSEs, credit was not always available evenly or in sufficient amounts to such borrowers, partly because of restrictions imposed by banking laws and regulations on interstate banking and intrastate branching of financial institutions. Additionally, many investors did not wish to invest in agricultural, housing, and student loans because these loans could not be sold easily. Moreover, they had relatively small principal amounts that made them hard to administer, and carried risks that were difficult to evaluate and price. GSEs were created to overcome these problems.
GSEs use two basic approaches to accomplish their statutory purposes: portfolio lending and financial guarantees. As portfolio lenders, GSEs either purchase assets in the form of loans that others have made or make loans directly and then hold them to earn interest. Sallie Mae, the FCBs, the BCs, and the FHLBs, which operate primarily as portfolio lenders, obtain most of their funding by selling to investors debt instruments that are general obligations of the GSE. Generally, portfolio lenders seek to maximize the difference between the interest earned on their loans and purchased assets relative to the interest paid on their debt securities. Financial guarantors, in contrast, earn income through the collection of fees from providing guarantees on securities backed by loans. This operating method does not necessarily require GSEs to issue debt securities. Farmer Mac operates primarily as a guarantor of securities. Freddie Mac operates mainly as a guarantor but also holds a mortgage portfolio. Fannie Mae is both a lender and a guarantor.
Scope and Growth of GSE Activity
The role of GSEs in the national credit markets has expanded dramatically over the years. At the end of Fiscal Year 1989 -- which according to government accounting runs between October 1, 1988 and September 30, 1989 -- outstanding obligations of GSEs in the form of guaranteed loans and debt borrowing totaled $836 billion. Five years later, this total had grown to nearly $1.6 trillion -- an increase of 90 percent. In contrast, over the same period, total liabilities of FDIC-insured commercial banks increased by only 16 percent, from $3.1 trillion to $3.6 trillion. Much of the increase in GSEs' obligations reflects the rapid expansion of Fannie Mae and Freddie Mac home mortgage financing in the credit markets through the issuance of mortgage-backed securities (MBSs). 3 Such securities increased from $467 billion in 1989 to $987 billion in 1994 (Table 1).
Fannie Mae was created in 1968 and Freddie Mac in 1970. Both are designed to provide
liquidity and a secondary market for residential mortgages. At the end of Fiscal Year 1994, Fannie Mae had a mortgage portfolio of $196 billion and MBSs of $482 billion. Freddie Mac, which operates largely as a guarantor, had a mortgage portfolio of $84 billion and MBSs of $464 billion.
The Federal Home Loan Bank System encompasses 12 districts, each with its own FHLB. The 12 Banks were established in 1932 to ensure the liquidity of member savings-and-loan associations and mutual savings banks. The FHLBs, which are owned by their member institutions, obtain most of their financing from the issuance of bonds and discount notes. Other significant financing sources include member institutions' deposits and retained earnings. From 1989 to 1994, the debt of the FHLBs rose from $144 billion to $170 billion (Table 1).
The Farm Credit Banks and the Banks for Cooperatives constitute two of the three main pillars of the nation's farm credit system. The third pillar is comprised of local associations, agriculture-related cooperatives, and rural utilities, to which they lend money in order to facilitate credit to farmers. Operating primarily as portfolio lenders, FCBs and BCs either purchase assets to hold in their portfolios, make loans, or both. Each institution is owned by its borrowers, and each obtains most of its funds by selling debt securities to investors. The securities are issued through a common financing vehicle called the Federal Farm Credit Banks Funding Corporation. This entity, which serves as the fiscal agent for the Farm Credit Banks and the Banks for Cooperatives, is responsible for marketing their system-wide consolidated notes and bonds. The debt securities are the 'joint and several' obligation of member FCBs and BCs; therefore, if one member defaults, the other members are responsible for its debt.
The Agricultural Credit Act of 1987 required each of 12 district Land Banks and the 12 district Intermediate Credit Banks to merge and form the Farm Credit Banks. In July 1988, 11 of the Land Banks and 11 of the Intermediate Banks merged to form the 11 FCBs. No merger occurred in one district because its Land Bank was in receivership. The resultant FCBs operate under statutory authority that combines the prior authorities of the Land and Intermediate Credit Banks. For Fiscal Year 1994, the FCBs' debt outstanding was $41 billion, down from $43 billion in 1989.
The Banks for Cooperatives, established in 1933, provide about two-thirds of all credit extended to U. S. agricultural and rural utilities cooperatives. The same Act that established the FCBs also provided authority for consolidation of the BCs. Eleven of the 13 district BCs voted in 1988 to merge into a single National Bank for Cooperatives. The BCs in two districts voted to remain independent, but they too have nationwide lending authority. Funds to finance their loans are obtained through the sale of bonds and notes to the public. In 1994, BCs had $14 billion of outstanding notes and bonds, up from $12 billion in 1989.
Farmer Mac, which also was established by the Agricultural Credit Act of 1987, is designed to facilitate the development of a secondary market for agricultural real-estate and rural housing loans. Farmer Mac operates basically as a guarantor of asset-backed securities, whereby an asset-backed security is created through pooling. In this process, private organizations, called poolers, purchase agricultural real-estate and rural housing mortgage loans from originating financial institutions, and then package and sell the loan pools to investors. Farmer Mac guarantees that the principal and interest on the purchased securities will be paid according to a schedule. This style of operation does not require Farmer Mac to issue debt securities: its operations are financed entirely through earnings from guarantee fees and the sale of capital stock. As of the end of Fiscal Year 1994, Farmer Mac-guaranteed mortgage-backed securities outstanding totaled $463 million, compared to $496 million one year earlier.
Sallie Mae, which was created in 1972 for the purpose of providing liquidity and enhancing the availability of credit to higher education, raises operating funds generally through debt securities or equity capital. It is primarily a portfolio lender. The funds raised are mostly used to: (1) purchase student loans from banks and other institutions; (2) make loans to financial institutions so that they can make more student loans; (3) guarantee student loan revenue bonds; and (4) invest in academic facility bonds. At the end of Fiscal Year 1994, Sallie Mae's debt totaled $50 billion, up from $32 billion in 1989.
Safety Nets, Regulation, and Special Advantages
Existing ties to the U.S. Government both constrain and benefit the GSEs. To enable them to achieve their public purposes, their charters grant them special privileges under federal law. At the same time, the range and scope of GSEs' activities are subject to federal controls in order to minimize the risk to the federal government.
As indicated in Table 2, responsibility for monitoring and regulating the activities of GSEs is divided currently among several Executive Branch agencies. The Department of Housing and Urban Development (HUD) has general regulatory authority over the activities and programs of Fannie Mae and Freddie Mac. 4 The Federal Housing Finance Board (FHFB) has broad administrative powers over the FHLBs, including control over budgets and salaries. The Farm Credit Administration (FCA) oversees the operations of the BCs, FCBs, and Farmer Mac. No federal entity has statutory authority to supervise the business operations or capital adequacy of Sallie Mae. With the exception of the BCs and FCBs, the President of the United States has the authority to appoint some members, though a minority, to each GSE's board of directors, as shown in Table 2. Also, Sallie Mae's Chairman of the Board is selected by the President.
GSE Links to the Federal Government
Fannie Freddie Farmer Sallie
Feature Mae Mac FHLBs FCBs Mac Mae
Chartered by Congress Yes Yes Yes Yes Yes Yes
Subject to GAO audit Yes Yes Yes No Yes No
Federal regulator HUD HUD FHFB FCA FCA None
ownership Private Private Private Private Private Private
President or presidential
appointees appoint some Yes Yes Yes No Yes Yes
board members (5/18) (5/18) (6/14) (N/A) (5/15) (7/21)
Treasury lending authorized $2.25B $2.25B $4.0B No $1.5B $1.0B
Eligible for Fed open-market
purchases Yes Yes Yes Yes N/A Yes
Use Fed as fiscal agent Yes Yes Yes Yes Yes Yes
Eligible to collateralize
public deposits Yes Yes Yes Yes Yes Yes
Exempt from SEC registration Yes Yes Yes Yes No Yes
Exemption of corporate earnings
from federal income tax No No Yes Yes No No
Exemption of corporate earnings
from state and local income tax Yes Yes Yes Yes No Yes
Exemption of interest paid
from state income tax No No Yes Yes No Yes
Source: Department of the Treasury, 'Report to the Secretary of the Treasury on
Government-Sponsored Agencies' (May 1990).
FCA = Farm Credit Administration
FHFB = Federal Housing Finance Board
GAO = Government Accounting Office
HUD = Department of Housing and Urban Development
SEC = Securities and Exchange Commission
The regulatory process requires that the Secretary of the Treasury approve all GSE debt and mortgage-related securities issued, with one exception: securities issued by the agricultural GSEs are approved by the FCA. However, the Secretary uses this authority primarily to coordinate the timing of Treasury and GSE issuances so that the securities are marketed in an orderly fashion. The Department of the Treasury does not evaluate the business operations or capital adequacy of the GSE as part of the approval procedure.
Federal legislation provides GSEs with several advantages that tend to raise GSEs' profitability by lowering their operating costs and increasing the liquidity of their debt. Each GSE, except the FCBs and CBs, may borrow from the U.S. Treasury in case of need. The credit line ranges from $1 billion for Sallie Mae to $4 billion for the FHLBs. Except for Farmer Mac, the lines of credit are at the discretion of the Treasury Department, although no rules or guidelines exist currently regarding the conditions under which such credit may be granted or denied. Farmer Mac has a $1.5 billion credit line with the U.S. Treasury under specific provisions contained in the Agricultural Credit Act of 1987. The other two farm credit institutions -- FCBs and BCs -- may obtain emergency credit through the Farm Credit System Financial Assistance Corporation, which was set up by the 1987 Act to provide funds to member institutions experiencing financial difficulties.
Most GSEs also enjoy certain tax exemptions. The corporate earnings of the FCBs and the
FHLBs are exempt from federal, state, and local income taxes. 5 Earnings of the BCs, however, are fully taxable by all three levels of government. Fannie Mae, Freddie Mac, and Sallie Mae are exempt from state and local income taxes. The income earned by investors in debt securities of the FCBs, BCs, FHLBs, and Sallie Mae is exempt from both state and local taxes. In addition, all GSEs, except Farmer Mac, are exempt from registering their debt and mortgage-backed securities with the Securities and Exchange Commission.
The securities of GSEs have many of the same attributes and preferred investment status as Treasury debt. They can be used as collateral for public deposits and for borrowing from Federal Reserve and Federal Home Loan Banks, which make them desirable acquisitions for commercial banks and thrifts. Also, the Federal Reserve can buy and sell the securities of GSEs in open-market operations. Finally, GSE securities are issued and traded through the Federal Reserve's book-entry and electronic funds transfer system, which further enhances their liquidity. As a result of these attributes, investors have come to believe that GSE securities are about as safe and liquid as Treasury debt notwithstanding the fact that the U.S. Government has no legal obligation to provide assistance to GSEs or to otherwise enable them to meet their financial obligations.
Capital Adequacy, Profitability, and Exposure to Risk Equity Standards Capital enables a financial institution to cope with unexpected
financial problems without becoming insolvent. The capital of GSEs generally includes stock (paid-in equity) and retained earnings. In some cases, a GSE is permitted to include subordinated debt as part of capital. The farm credit GSEs, the FHLBs, Fannie Mae, and Freddie Mac are subject also to minimum capital requirements set by their regulators.
Some GSEs operate with substantially lower capital ratios than are required of FDIC-insured institutions. Among other capital requirements, FDIC-insured institutions currently are required to maintain total capital of at least eight percent of risk-weighted assets. As discussed below, only the FCBs and the BCs have capital ratios that approach those of banks. The question whether banks and GSEs ought to have similar capital ratios is beyond the scope of this paper. It involves issues about the risk-return profiles of banks versus GSEs, competitive equity, and public policy toward the sectors the GSEs were designed to promote.
Sallie Mae. No minimum capital requirement is specified in Sallie Mae's charter. Instead, the U.S. Government has allowed Sallie Mae to choose its own capital level. Sallie Mae determines its capital level primarily through discussions with rating agencies, investment bankers, and by monitoring its stock price and earnings per share. 6
Since 1986, Sallie Mae has been paying out a portion of its retained earnings to repurchase voting and nonvoting common stock and preferred stock, all of which are included in Sallie Mae's definition of stockholder equity. Because Sallie Mae's assets grew rapidly during this period, the use of retained earnings to repurchase stock restricted the growth of stockholder equity. As a result, the agency's equity-to-assets ratio declined from 5.4 percent in Fiscal Year 1984 to 2.9 percent in 1994 (see Figure 1). While caution is required in making comparisons due to differences in the risk characteristics of banks and GSEs, an FDIC-insured institution with this capital ratio would be considered 'significantly undercapitalized.'
Fannie Mae and Freddie Mac. Capital-to-assets ratios for these GSEs depend on the measure of assets used in the calculation. Fannie Mae and Freddie Mac list mortgage-backed securities as an off-balance-sheet item -- only direct portfolio holdings are listed as assets. Although this practice is consistent with GAAP principles as they apply to private corporations, a number of recent studies have argued that because these agencies are exposed to potential loss on MBSs through their guarantee of principal and interest, such securities should be included in their capital adequacy measures. 7 The graphs in Figure 1 illustrate the difference between the two concepts.
It is interesting to compute Fannie Mae and Freddie Mac's capital ratios using the same approach that would be used for an FDIC-insured institution. Residential mortgages receive a 50 percent risk-weight under banks' current risk-based capital standards. Similarly, if a bank were to sell a residential mortgage while providing a guarantee of principal and interest, these loans sold with recourse would also receive a 50 percent risk-weighting. To estimate the risk-based capital ratios for Fannie Mae and Freddie Mac, assume that all their mortgage assets, on- and off-balance-sheet, have a 50 percent risk-weighting. Using this approach, Fannie Mae's ratio of total capital to risk-weighted assets as of September 30, 1994, was 2.47 percent; the comparable ratio for Freddie Mac was 1.88 percent. For an FDIC-insured institution, as noted, the required capital ratio against risk-weighted assets is eight percent. As mentioned earlier, of course, there are differences in the risk profiles of banks versus GSEs that may make such comparisons difficult. For example, the mortgage-related assets of these GSEs are better
diversified geographically than those of the typical FDIC-insured institution.
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 establishes
identical new statutory capital requirements for Fannie Mae and Freddie Mac. Three different capital standards are specified: a minimum capital standard, a critical capital standard, and a risk-based standard. After a transition period that ended in April 1994, each GSE's minimum capital must equal the sum of: (1) 2.50 percent of on-balance-sheet assets, (2) 0.45 percent of outstanding MBSs, and (3) 0.45 percent of other off-balance-sheet obligations.. 8 The applicable percentages for compliance with the critical standard are 1.25, 0.25, and 0.25 percent, respectively. By year-end 1995, OFHEO is required to develop and implement a risk-based capital standard that includes credit and interest-rate-risk components, plus additional capital for management and operations risk. 9
Federal Home Loan Banks. The FHLBs' capital is owned entirely by their members. The law requires members to hold capital on their respective FHLBs equal to the greater of: 0.3 percent of the member's total assets, 1.0 percent of the member's mortgage-related assets, or 5.0 percent of a member's outstanding advances. The FHLB system currently does not have a risk-based capital standard. Membership originally was limited to savings-and-loan associations, savings banks, and insurance companies. In 1989, FIRREA extended voluntary membership in the FHLB system to commercial banks and credit unions.
The capital-to-assets ratio for the combined system in recent years has fluctuated around the seven percent level. Although several recent studies found this ratio adequate,. 10 a new CBO study (1993) offers an antithetical view.
According to the study, one should regard almost all of the FHLBs' equity capital as being
financed through borrowed funds, federally insured deposits, rather than members' own capital. Moreover, some of the FHLB stock is not permanent capital, but instead can be redeemed at par at the request of members. Thus, according to the Congressional Budget Office (CBO), although the FHLBs may appear well-capitalized, little of that capital is available to absorb losses without increasing the risk to the FDIC reserve fund.
Farm Credit Banks and Banks for Cooperatives. The capital of these farm-credit
institutions comes basically from two sources: direct investments by members and retained earnings. Direct investment consists of voting common stock, which the members must hold in order to obtain loans from the system. Although the Agricultural Credit Act of 1987 set the minimum stock-purchase obligation to the lesser of 2.0 percent of each borrower's outstanding loan or $1,000, each FCB or BC may require more if necessary to meet its regulatory capital requirements.
Figure 1 shows trends in capital-to-assets ratios for FCBs and BCs after the system was
recapitalized in 1988. The capital ratios of these institutions have been increasing since 1988, and currently stand much higher than those of other GSEs.
As provided by the 1987 Act, new capital adequacy standards based on risk went into effect at the beginning of 1993. They require permanent capital (which excludes loan-loss reserves and 'protected' borrower stock, i.e., stock issued before the 1988 reorganization and redeemable at par) to be at least seven percent of risk-adjusted assets for each FCB and BC.
With the exception of Fannie Mae in the early 1980s and the farm credit institutions prior to their restructuring in 1988, the GSEs have been consistently profitable through the past decade. Figure 2 presents information on profitability, as measured by the ratio of net income after taxes to equity balance at year-end. Currently, Sallie Mae is by far the most profitable GSE. Its return on equity in recent years has been around 30 percent. 11
After experiencing heavy losses in the early 1980s, Fannie Mae returned to profitability in the mid-1980s, reaching equity returns in the 25 percent range. Freddie Mac has been profitable since its inception, although during the 1990s its rate of return on equity has been declining. The guarantee activity of Fannie Mae and Freddie Mac has made an important contribution to their profitability. For calendar year 1993, Fannie Mae earned $961 million in guarantee fees, as compared with $2.5 billion of net interest income from its securities portfolio. In 1993, Freddie Mac's guarantee income totaled to $1.0 billion, compared to $1.9 billion of net interest income. These guarantee fee incomes as a percentage of their average balances of MBSs outstanding in 1993 were 0.21 (21 basis points) for Fannie Mae and 0.24 for Freddie Mac. In 1984, the average fee for either GSE was 25 basis points (Fannie Mae and Freddie Mac Annual Reports).. 12
Like Freddie Mac, the Federal Home Loan Banks have experienced a declining profit rate in recent years. According to the CBO's 1993 study, a main reason for the decline has been the $300 million annual payment that the FHLBs are required to make to the Resolution Funding Corporation (REFCORP), the off-budget agency established to borrow money to help finance the resolution of failed thrifts. Under current law, each FHLB has to pay 20 percent of its net income to REFCORP. If the combined amount is less than $300 million, the shortfall is paid by each district FHLB in proportion to the share of advances it makes to members insured by the Savings Association Insurance Fund. This requirement, also, can discourage the FHLBs from making advances to savings-and-loan institutions.
Profitability of the BCs and FCBs has improved from the massive losses of the mid-1980s. Rates of return on equity are positive, ranging to ten percent or better. Reasons for the improvement include reductions in nonperforming assets, improved interest-rate margins as high-cost debt matured, and more effective asset-liability management.
To carry out their programs and remain profitable, GSEs take risks. Like other private financial institutions, GSEs face risks primarily from loan defaults and changes in market interest rates. Each of the GSEs utilizes strategies to avoid certain risks and minimize losses.
Credit risk is the risk of loss due to default by the borrower. Both portfolio lenders and MBS guarantors are subject to credit risk. As lenders, GSEs are exposed to losses on assets they hold. As guarantors, they are liable for losses on assets over which they have extended their guarantees. There are two basic measures of credit risk: volume of assets and insured MBSs that are not performing, and the dollar amount of losses to the GSE resulting from the nonperforming assets or insured MBSs.
The extent of each GSE's exposure to credit risk varies. Sallie Mae and the FHLBs are exposed to the least amount of credit risk. This is not because their borrowers are least likely to default; rather, it is because the risk is shifted elsewhere. The federal guarantee of the student loans financed by Sallie Mae means that virtually all default losses accrue to the U.S. Government, provided that the GSE complies with federal regulations regarding the servicing of student loans. Likewise, the FHLBs' main lending activity -- advances -- involves virtually no credit risk because: (a) advances are collateralized with high-quality assets; (b) the FHLBs can tap their members' stock investment if the collateral proves deficient; and (c) the collateralization feature ensures that the FHLBs would be first in line for payment in the event of the borrowing member's bankruptcy.
Fannie Mae and Freddie Mac face more credit risk, mainly because residential mortgages are more risky than government guaranteed student loans or fully collateralized advances. Exposure to credit risk arises from the possibility that the two GSEs will not recover amounts due from borrowers on mortgage loans in their portfolios or on loans backing MBSs that they guarantee. This risk is managed mainly through application of loan-to-value ratios and other underwriting standards for loans the GSEs acquire or guarantee and, to a lesser extent, through product diversification. The loan-to-value ratio is important because the amount of equity in a home mortgage has been found to be a key determinant of loan default incidence. In the same vein, both GSEs concentrate primarily in fixed-rate mortgages, because fixed-rate products generally have less credit risk than adjustable-rate mortgages (ARMs). ARMs present a greater danger of default risk because the %0% interest rate and monthly mortgage payment are tied to a specified market-rate index which varies within limits with changing economic conditions.
An indicator of credit risk is the loan-to-value ratio. As of December 31, 1993, the average loan-to-value ratio for conventional, single-family portfolio or MBS mortgages was 72 percent for Fannie Mae and 66 percent for Freddie Mac, up slightly in both instances from the previous year's levels. Another measure of credit risk is the rate of serious delinquencies in single-family mortgages, defined as the percentage of individual loans in portfolio or in MBS issues that are delinquent 90 days or more. This rate for Fannie Mae was 0.63 percent in 1992 and 0.56 percent in 1993. In the case of Freddie Mac, the corresponding percentages were 0.64 and 0.61. By comparison, the percentage of nonperforming 1-4 family residential real-estate loans for FDIC-insured commercial banks at year- end 1993 was 1.19 percent.
The FCBs and BCs are exposed to a higher level of credit risk relative to other GSEs because their loan repayments depend on the unpredictable nature of agricultural income. Farmer Mac only recently began operations, but its underwriting standards require loan poolers and originators to assume responsibility for the first ten percent of credit losses from each guaranteed pool.
Interest-Rate Risk. GSEs engaged in portfolio lending are exposed also to possible losses due to interest-rate risk when the value of a GSE's assets and the value of its liabilities react differently to changes in market interest rates.. 13 In addition, interest-rate changes alter the speed of mortgage prepayment, which affects the flow of guarantee income and can even create capital gains and capital losses for the GSE.
A comparison of the maturities of assets and liabilities gives GSEs an indication of their
interest-rate-risk exposures. If, for example, the dollar volume of liabilities maturing in a given time interval is greater than the dollar volume of assets, then interest expenses will likely change more than interest earnings if market interest rates change. Other indicators of interest-rate risk involve estimating the sensitivity of the present values of assets and liabilities to changes in market interest rates. These duration measures allow estimates of the change in net worth resulting from a small change in interest rates.
GSEs can manage their interest-rate-risk exposure by lengthening or shortening the expected maturity of their assets and liabilities so that payment flows on assets and liabilities behave similarly. The significance and management of interest-rate risk vary widely among GSEs. Management of interest-rate risk is particularly important for Sallie Mae, Fannie Mae, the FHLBs, and farm credit institutions because of their holdings of loan assets. Sallie Mae and the FHLBs have managed interest-rate risk successfully by closely matching the interest-rate sensitivity of assets and liabilities in their portfolios (Treasury, 1991). These sensitivities are not as well matched by FCBs, BCs, Fannie Mae or Freddie Mac, but these GSEs use other techniques, such as adjustable-rate loans, interest-rate swaps and callable debt, to limit interest-rate risk.
The Competitive Effects of GSEs on Banking Institutions
GSEs have had a major effect on the competitive landscape facing banking firms. They are strong competitors for funds. Their liquidity-enhancing activities have driven down yields available for bank assets, especially mortgage assets. The growth of securitization and mortgage derivatives products, made possible primarily through GSE activity, has altered the opportunities and risks available to banks.
The Cost and Ability to Raise Funds in Credit Markets
Market pricing of GSE debt relative to Treasury debt suggests that the agency guarantee is
viewed as comparable to the full faith and credit backing behind Treasury issues. This gives GSEs a clear advantage over private business when raising funds in the capital markets. Moreover, the advantage of agency status applies to all of the debt obligations of the GSEs, in contrast to federal insurance of deposits, which is limited to $100,000 per depositor. Although uninsured deposit claims often have been covered in bank failures in the past, recent legislation has narrowed substantially the number of instances where uninsured deposits receive insurance coverage.
GSE debt trades in the financial markets as 'agency debt,' implying that it is treated by market participants as though it were nearly equivalent to Treasury debt.. 14 The two major rating agencies, Standard and Poor's and Moody's Investors Service, categorize the credit quality of GSE debt they rate as AAA. If these ratings agencies were to apply a credit assessment without considering the government ties, not all of the GSEs necessarily would earn the highest rating. In 1991, at the Treasury Department's request, Standard and Poor's rated GSEs under the assumption that they would have to meet all future obligations entirely from their own resources. Only the FHLBs and Sallie Mae earned the AAA rating. Freddie Mac was rated A+, Fannie Mae A-, while the FCBs and BCs were rated BB (Treasury, April 1991, A-1). It has been reported (Goodman and Passmore, 1992, p. 5) that AA-rated private pass-through securities such as CMOs have traded at yields 45-60 basis points above Fannie Mae/Freddie Mac (AAA-rated) pass-throughs. This provides some indication how
the borrowing cost might rise if a GSE lost its implicit guarantee and did not receive S&P's triple-A rating. But even the GSEs that could earn the AAA rating on the strength of their own resources would probably incur significant additional costs if they were denied their government ties. The same study indicates that non-GSE, private CMOs with a triple-A rating had been trading about 40 basis points above comparable Fannie Mae issues. The market seems to be valuing Fannie Mae's corporate guarantee as better than AAA.
In short, the agency status of GSEs assures them lower funding costs and easier access to market funds, almost without regard to the GSEs' capital positions or operating performance. For example, when interest rates rose in the early 1980s, Fannie Mae experienced heavy losses. A 1986 HUD report found Fannie Mae to be insolvent on a mark-to-market basis during the years 1978 through 1984. At times during this period, its interest spread over Treasury securities temporarily increased, but Fannie Mae was able to continue borrowing large sums, raising some $95 billion in short- and long-term funds during 1981 and 1982. Similar events emerged in the case of the farm credit system, when several of its institutions were in danger of failing during the mid-1980s. Troubled institutions continued to receive funding even after it became apparent that they could not survive without federal aid. These events led the GAO to infer that Fannie Mae and the farm credit institutions '. . . would have faced much higher costs of funds or been
denied credit entirely during the periods of stress without the likelihood of federal assistance.'
To the extent that GSEs are perceived as having the equivalent of the full faith and credit of the U.S. Government behind them, they have advantages in raising funds similar to insured deposits at banking institutions. There are, however, important differences in the cost and scope of federal protection of the obligations of GSEs versus banks. GSE obligations have no explicit federal protection but are priced in the marketplace as if there were such protection. Banks, on the other hand, have explicit federal protection for only a portion of their obligations (deposits under $100,000): since the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), uninsured depositors have suffered some loss in the majority of bank failures. Because of the more stringent FDIC cost test required by FDICIA, uninsured depositors can often expect to receive only their pro rata share of the proceeds from the receivership of the failing bank. The other important difference relates to cost. Banks pay deposit insurance premiums on their entire domestic deposit base (including uninsured deposits); GSEs, lacking explicit federal guarantees, pay no premiums for the implicit protection they enjoy.
Competitive Forces on the Lending Side
The development of secondary markets through the auspices of GSEs have broadened and
increased the efficiency of capital markets. These developments have brought new investors into markets, thereby increasing the availability and lowering the cost of consumer credit. The most dramatic effects have occurred in the market for home mortgage credit. The rapid growth of securitized pools of home mortgages as investment vehicles, which is in the next section, has increased substantially the liquidity of many home mortgages. As a result of this liquidity enhancement, competitive pressures have bid down the required returns on these mortgages.
In short, it has become less attractive to hold mortgages in portfolios. It has been estimated that interest rates on fixed-rate mortgages conforming to secondary market specifications may have been lowered by upwards of 30 basis points by the broadening effect of GSE activity.. 15 This is a substantial benefit to the consumer. 16 It also has an adverse effect on banking institutions by narrowing their 'spreads' and profitability. In fact, it has been argued that insured depository institutions may not, in the long run, be able to act profitably as portfolio lenders of conforming home mortgage loans, given their cost structure. 17 18
Securitization and the 'Technology' of Intermediation
GSEs have been instrumental in the most far-reaching securitization of non-corporate,
non-government credit that has occurred to date. Securitization represents a basic change in the 'technology' by which intermediation takes place between savers and borrowers in the market. While this technology now dominates the market for mortgages and is an active part of other markets, depository institutions still play a major role in the intermediation process.
Looking again at the case of home mortgages, traditional intermediation took place through a single institution, typically a thrift, that issued one type of obligation to savers, savings deposits, and purchased a very different type of obligation from borrowers, mortgages. Because these instruments differ in degree of liquidity, term-to-maturity, and other basic characteristics, the traditional thrift was exposed to interest-rate risk and liquidity risk in addition to the basic credit risk associated with lending. The advantage of a large institution in managing these risks was the benefit of portfolio diversification. This traditional portfolio lender performed all of the basic functions involved in underwriting, originating, funding and servicing the mortgage instrument, thereby earning returns that compensated it for assuming portfolio risk.
This description of a traditional mortgage intermediary is useful as a comparison to the vastly different technology currently in use in mortgage securitization. In basic terms, securitization involves two or more specialized intermediaries that operate between savers and borrowers in the mortgage market. The first is the mortgage pool, a trust that purchases mortgages from borrowers and issues GSE-sponsored securities in large denominations to the credit markets. These pass-through securities are identical to the underlying mortgages with respect to term-to-maturity and prepayment or interest-rate risks; they carry less credit risk due to the agency guarantee of principal and interest; and they are made more liquid than the underlying mortgages by the existence of an active secondary market. This enhanced liquidity has reduced the yields available to holders of these mortgages and transformed the mortgage lending business. Mortgage loans meeting Fannie Mae's or Freddie Mac's underwriting standards are sold typically in the secondary market rather than held on the books of depository institutions.
The advantages of securitization for risk management include the ability for each intermediary to specialize and to make use of the secondary market -- rather than portfolio diversification -- to provide liquidity to savers. Securitization also has encouraged the development -- often fostered by the GSEs themselves -- of standard market practices. That standardization reinforces the underlying technological reasons allowing specialization, or 'unbundling' of the underwriting, originating, funding and servicing functions. Specifically, standardization has facilitated the use of advanced information technologies to carry out both routine underwriting and other monitoring functions, and to effectively price mortgage-backed instruments in the secondary market. This, in turn, has led to large-scale entry in many mortgage-related lines of business, with the predictable effect of lowering prices charged to borrowers.
Depository institutions play a continuing role in these markets by providing one or more of the unbundled mortgage services to their customers. They originate mortgages for sale to the secondary markets, purchase MBS issues for their portfolio, and service mortgage loans for other lenders. In this way, banks and thrifts take advantage of the secondary-market liquidity and information technologies to earn profits in much the same way as non-bank mortgage market participants.
Newer techniques differentiate and compartmentalize the interest-rate and prepayment risks from the original mortgages through the creation of multiclass securities. These securities often are referred to as 'derivative' products because they are derived from ordinary mortgage-backed issues. Both Fannie Mae and Freddie Mac currently issue multiclass MBSs such as collateralized mortgage obligations (CMOs) and real-estate mortgage investment conduits (REMICs). Typically, the cash flows from derivative mortgage products are rearranged to reflect the interest-rate risk and maturity preferences of potential investors. Some of these derivative instruments may contain considerable downside risk in a rising interest-rate environment, while under the same conditions others may actually appreciate in value. From the standpoint of banks and thrifts then, derivative securities are valuable for two main reasons. First, by offering a broad range of maturities (tranches), REMICs and CMOs are useful for match-funding of assets by banks and thrifts. Second, because certain types of derivatives increase in value when interest rates rise and decline in value when rates fall, they can be used as hedges against assets whose market value moves counter to interest rates.. 19 The risks and opportunities afforded by the use of
mortgage derivative products have been the subject of considerable study and debate. As with the growth of securitization, this is an area in which the activities of GSEs have transformed the competitive landscape for depository institutions.
With outstanding obligations exceeding $1.5 trillion, government-sponsored enterprises are
well-established as major participants in the nation's money and capital markets. The first GSE onnection to these markets occurred in 1916, when the Federal Land Banks were created. The latest entry in 1988, Farmer Mac, suggests that the federal government continues to regard the GSE vehicle as an important instrument of public policy.
Like other financial concerns, GSEs are subject to financial risk. They can lose money, for example, when their loans are not repaid or when changes in market interest rates adversely affect the value of their assets. In the private sector, the greater the risk of loss assumed by an institution, the higher its cost of raising market funds. The market's perception of an implicit government guarantee of agency debt, however, erodes the link between the GSEs' cost of funds and the riskiness of their behavior. As discussed in the paper, there have been episodes where GSEs have been able to fund themselves despite large losses or economic insolvency. Thus, the perception of an implicit guarantee of GSE debt creates a potential breakdown of market discipline and a need to circumscribe the risk-taking behavior of these enterprises.
The federal government has attempted to do this by imposing capital standards on GSEs that reflect the riskiness of their activities. These standards are designed not only to provide a buffer for possible GSE losses, but also to ensure equity across financial institutions that compete with the GSEs. For example, since the Farm Credit Banks and the Banks for Cooperatives compete directly with commercial banks, their capital requirements are patterned after bank risk-based capital rules. Nevertheless, there are substantial differences in capitalization between banks and some GSEs. While comparisons are difficult because of differences in risk-return profiles, Fannie Mae, Freddie Mac and Sallie Mae operate with substantially less capital than would be required of FDIC-insured institutions.
GSEs compete with banking institutions on both sides of the balance sheet. They make loans such as mortgages, farm loans, and student loans, and they also compete in the credit markets to borrow funds in order to finance their loans. In the financial markets, GSEs seem to enjoy some clear-cut advantages over banks. A key advantage relates to economies of scale in raising funds. As financial 'middlemen,' GSEs can raise funds nationally through large-scale issuance of standardized, highly liquid securities and pass on these funds in smaller denominations to banks and other borrowers, who disaggregate the monies into still smaller quantities for lending to businesses and individuals. There are thus cost savings due to scale economies in all intermediate steps. This in many respects is the reverse of the process for banks, whereby banking institutions raise local funds in relatively small amounts, often through costly branch offices, and aggregate those funds for typically larger loans to business firms. Some additional cost savings accrue because GSE securities are exempt from SEC registration requirements, deposit insurance premiums, and exempt in many cases from state and local income taxes.
On the asset side, the most prominent area of competition is in housing finance. The advent of securitization and the variety of mortgage-related securities issued by Fannie Mae and Freddie Mac has eliminated the liquidity and size disadvantages faced by investors who wish to hold long-term, fixed-rate mortgages. This, in turn, has led to a significant reduction in mortgage yields, making it less desirable and less profitable for banks and thrifts to fund and hold long-term mortgages.
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