Problems at Freddie Mac and Fannie Mae Secondary Mortgage Market Implicit guarantee Strategies Problems Preemptive Actions

Secondary Mortgage Market Banks and other financial institutions offering mortgage in the primary market sell mortgage to Freddie Mac and Fannie Mae Freddie Mac and Fannie Mae package these loans

Implicit Guarantee The federal government will bail out them when they experience financial distress More importantly, both agencies take credit from this implicit guarantee – securities are viewed almost risk free

Pass Through Strategy Packaging loans to MBS and sell them to investors, earn a return 0.19% -- “pass through” strategy

Mortgage Investment Strategy Buy MBS, thus regain interest rate risk –highly profitable – big spread between MBS return and debt-funding ratio: 1.04% in 2001 –Very high leverage Fannie and Freddie have a combined outstanding debt that is 39 percent of total outstanding US public debt

Problems Rising interest rate  value of mortgage goes down Decreasing interest rate –Mortgage borrowers pay their loan or refinance, receiving less payment for mortgage loans they keep –Less money to meet debt payment requirement

Essence of Problem ??

Preemptive Actions Accounting and disclosure requirements Monitoring on both agencies’ interest rate risk and leverage