Subordinated Debt Issuance by Fannie Mae and Freddie Mac

Abstract:     
Considerable research has been done on the use of subordinated debt as a source of market discipline for banking organizations. However, little research has been done on the use of such debt as a source of market discipline for Fannie Mae and Freddie Mac. Critics of the subordinated debt programs of the Enterprises have argued that the market may perceive an implicit guarantee of their subordinated debt, in which case the observed changes in subordinated debt yield spreads, rather than reflecting changes in investor perceptions of Enterprise risk, reflect the influence of other factors.

The paper found that the subordinated debt programs of Fannie Mae and Freddie Mac suffer from a number of shortcomings. In addition, while data show that Enterprise subordinated debt are somewhat sensitive to Enterprise financial risk - spreads between Enterprise subordinated and senior debt responded predictably to new information, similar to spreads between Enterprise senior debt and Treasury securities of comparable maturity - signals from the bond markets were generally not as strong or immediate and they tend to lag behind signals from the equity market. Moreover, statistical analysis suggests that investors perceive an implicit federal guarantee of Enterprise subordinated debt and that that debt has contributed little to market discipline of Fannie Mae and Freddie Mac.

New regulatory authorities such as receivership authority could change the consensus of investors' perceptions of their potential for loss, increasing their incentive to monitor Enterprise risk. Other new regulatory authorities such as disclosure requirements could increase the ability of investors to monitor Enterprise risks. The combination of greater ability to monitor risks and greater likelihood of suffering losses would likely produce stronger signals from the subordinated debt market that could change the behavior of Enterprise managements and OFHEO.

Keywords: Suboridnated debt, market discipline, government-sponsored enterprise

JEL Classifications: G21, G28

Working Paper Series